Interest Coverage Ratio: worked example
| Operating income (EBIT) | $480,000 |
|---|---|
| Interest expense | $120,000 |
| Interest coverage ratio | 4.00× |
| Fall in EBIT before interest is uncovered | 75.0% |
Common error: Using net income instead of operating income. Interest has already been taken out of net income, so the ratio would count the same cost twice.
Interest Coverage Ratio: formula
Interest is not the only fixed obligation: principal repayments, leases and preferred dividends also need cash. A firm with volatile earnings can have a good ratio one year and a bad one the next. Cash flow, rather than accounting profit, ultimately pays the interest, so check cash flow measures too.
Enter reported operating income (EBIT) and the defined interest expense for the same accounting period. Use the financial statements’ classifications consistently. If a separate analysis adjusts unusual items or capitalized interest, disclose those adjustments and compare it separately with the reported ratio; this model does not select the adjustments.
Interest Coverage Ratio: changing Operating income (EBIT)
| Operating income (EBIT) | Interest coverage ratio | Fall in EBIT before interest is uncovered |
|---|---|---|
| $384,000 | 3.20× | 68.8% |
| $432,000 | 3.60× | 72.2% |
| $480,000 (example) | 4.00× | 75.0% |
| $528,000 | 4.40× | 77.3% |
| $576,000 | 4.80× | 79.2% |
Interest Coverage Ratio: compare input ranges
| Input | Tested from | To | Interest coverage ratio: low input | Interest coverage ratio: high input | Swing |
|---|---|---|---|---|---|
| Interest expense | $108,000 | $132,000 | 4.44× | 3.64× | 0.81× (20%) |
| Operating income (EBIT) | $432,000 | $528,000 | 3.60× | 4.40× | 0.80× (20%) |
Interest Coverage Ratio: individual input comparisons
| Input | Value | Interest coverage ratio | Fall in EBIT before interest is uncovered |
|---|---|---|---|
| Operating income (EBIT) | $384,000 | 3.20× | 68.8% |
| $432,000 | 3.60× | 72.2% | |
| $480,000 | 4.00× | 75.0% | |
| $528,000 | 4.40× | 77.3% | |
| $576,000 | 4.80× | 79.2% | |
| Interest expense | $96,000 | 5.00× | 80.0% |
| $108,000 | 4.44× | 77.5% | |
| $120,000 | 4.00× | 75.0% | |
| $132,000 | 3.64× | 72.5% | |
| $144,000 | 3.33× | 70.0% |
Interest Coverage Ratio: combined input changes
| Operating income (EBIT) / Interest expense | $96,000 | $120,000 | $144,000 |
|---|---|---|---|
| $384,000 | 4.00× | 3.20× | 2.67× |
| $432,000 | 4.50× | 3.60× | 3.00× |
| $480,000 | 5.00× | 4.00× | 3.33× |
| $528,000 | 5.50× | 4.40× | 3.67× |
| $576,000 | 6.00× | 4.80× | 4.00× |
Interest Coverage Ratio: which assumptions move the result?
Interest Coverage Ratio: values and definitions
| Quantity and definition | Value used |
|---|---|
| Operating income (EBIT) | $480,000 |
| Interest expense | $120,000 |
| Interest coverage ratio | 4.00× |
| Fall in EBIT before interest is uncovered | 75.0% |
Interest Coverage Ratio: half and double Interest expense
| Interest expense | Interest coverage ratio |
|---|---|
| $60,000 | 8.00× |
| $120,000 | 4.00× |
| $240,000 | 2.00× |
Business Finance calculators: Asset Turnover Calculator, Operating Margin Calculator, Cost of Goods Sold (COGS) Calculator, DuPont Analysis Calculator, Employee Turnover Rate Calculator, Net Promoter Score Calculator.
Coverage asks a simple question: how many times over do operating earnings pay the interest bill? With $480,000 of operating income and $120,000 of interest, the answer is 4 times. Turn it around and it says earnings could fall by 75 percent before interest went unpaid.
Lenders watch this number because a bad year hits it first, long before the principal is at risk.
Use the same year for both figures, and check whether the interest number includes capitalized interest or only the amount expensed.
Test total debt service with the business DSCR calculator, and the debt-to-equity page for balance sheet debt. The EBITDA margin and operating margin pages show earnings quality, and the operating leverage calculator shows how volatile EBIT can be.
Does coverage of 4 mean four years of payments are funded?
No. Coverage is a dimensionless ratio, with no time unit. Cash balances and a future payment schedule are not entered.
What does the 75% result hold constant?
The $120,000 interest expense. Changing debt, rates or other obligations requires a new scenario.
What is a good interest coverage ratio?
Generally above 3 is comfortable and below 1.5 signals risk. Stable businesses can carry lower ratios than cyclical ones.
What does a ratio below 1 mean?
Operating profit does not cover interest, so the company must use cash reserves, sell assets or borrow more to pay it.
Should I use EBIT or EBITDA?
EBIT is stricter because depreciation reflects real asset wear. EBITDA is used by some lenders, and it gives a higher ratio.