What is the Interest Coverage Ratio?
The interest coverage ratio, also known as times interest earned, is a measure of how well a company can meet its interest-payment obligations.
Interest Coverage Ratio - Formula & Example
The interest coverage ratio is also referred to as the times interest earned ratio.
The interest coverage ratio formula is:
Interest Coverage = (Earnings Before Interest and Taxes) / (Interest Expense)
Here is some information about XYZ Company:
Net Income $350,000
Interest Expense ($400,000)
Using the formula and the information above, we can calculate that XYZ's interest coverage ratio is:
($350,000 + $400,000 + $50,000)/$400,000 = 2.0
This means that XYZ Company is able to meet its interest payments two times over.
Why does the Interest Coverage Ratio matter?
In general, a high coverage ratio may suggest a company is 'too safe' and is neglecting opportunities to magnify earnings through leverage. An interest coverage ratio below 1.0 indicates that a company is not able to meet its interest obligations.
Because a company's failure to meet interest payments usually results in default, the interest coverage ratio is of particular interest to lenders and bondholders and acts as a margin of safety. However, because the interest coverage ratio is based on current earnings and current expenses, it primarily focuses a company's short-term ability to meet interest obligations.
Some industries tend to have higher interest coverage ratios than others, and cyclical companies in particular can experience significant swings in their interest coverage ratios (especially during recessions). Thus, comparison of interest coverage ratios is generally most meaningful among companies within the same industry, and the definition of a 'high' or 'low' ratio should be made within this context.