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Interest Coverage Ratio
A ratio used to determine the number of times interest expense is earned from operating profits. Bankers utilize this ratio as do other lenders to decide how easily a company can pay interest on its outstanding debt. The numerator to use is EBIT (earnings before interest and taxes)
The formula is:
Interest Coverage Ratio = EBIT / Interest Expense
Example 1:EBIT = $500,000
Interest Expense = $100,000
Interest coverage ratio = $500,000 / $100,000
Interest Coverage ratio = 5
When putting together business plans to present to bankers or other potential lenders you should include this ratio with the financial performance metrics - they will want the calculation and if you present it all the better. When planning internally this is an important ratio - it allows the planners / stakeholders to determine whether the funds that will be needed will earn an appropriate return (either on an external or internal basis)
The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy interest expenses.
