Interest coverage ratio

The formula

• ICR = EBIT / I

EBIT is the operating profit, before interest and tax, and I the interest expense for the same period. The result is a multiple: how many times the year’s interest could be paid out of what the operation earned.

A worked example

An operating profit of 300,000 against 60,000 of interest: ICR = 300,000 / 60,000 = 5. The company earns its interest five times over. Turned round, a company with 300,000 of operating profit that wants to keep the ratio at 5 can afford 60,000 of interest a year.

Reading the number

At 1 the whole operating profit goes to the lenders and nothing is left for tax or the owners; below 1 the interest is paid from reserves or new loans. Lenders set covenants on this ratio, often somewhere between 2 and 3, because it is the earliest sign that a loan is becoming hard to carry: profit falls, or rates rise, and the multiple shrinks before any payment is missed.

Which profit

This page takes EBIT. Some analysts take EBITDA instead, since depreciation does not have to be paid in cash in the year, and get a higher ratio; a comparison has to use one or the other. The Swedish räntetäckningsgrad adds financial income to the profit before dividing.

Common mistakes

• Using net income. The interest has already been taken out of it.
• Mixing a year’s profit with a quarter’s interest. Both figures need the same period.
• Taking a high ratio for a safe balance sheet. A company with little debt has a high ratio and may still be short of cash.

Frequently asked questions