When it comes to using financial ratios to gauge your company’s performance and overall financial health, there are a variety of metrics you can chose from. Here on the Kashoo blog, we’ve talked about profitability ratios like Return on Assets, Operating Cash Flow Margin and the Debt Equity Ratio. Another ratio—one that lenders and investors find particularly useful—does double duty as both a debt and profitability ratio: the Interest Coverage Ratio.
What is the Interest Coverage Ratio?
The Interest Coverage Ratio is a way to measure your company’s ability to pay off the interest owed on any outstanding debt carried. Debt is pretty much unavoidable when you’re starting up a business, but debt itself isn't always a bad thing. That's why this ratio is a particularly useful one. It is sometimes also called “times interest earned" because it’s a measure of how many times over your company could theoretically pay off whatever interest you owe using your available earnings at the time the ratio is calculated.
How is the Interest Coverage Ratio Calculated?
The calculation for the Interest Coverage Ratio is fairly straightforward, although there are some variations that can apply.
The simplest formula used to calculate the ratio is:
Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense
Interest Expense is a non-operating expense and is found on your income statement. EBIT itself is a way to gauge your company’s profitability and is found by subtracting operating expenses from operating revenues.
There are a couple of variations on the numerator of this equation which can affect the Interest Coverage Ratio. The first of these is using Earnings Before Interest After Taxes (EBIAT) instead of EBIT. This offers a clearer picture of your company’s expenses since taxes play a big role in your business’s financial situation. This calculation will result in a lower Interest Coverage Ratio.
Another variation is using Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) in the numerator instead of EBIT. By excluding depreciation and amortization while keeping the Interest Expense the same, this variation results in a higher Interest Coverage Ratio than if you use EBIT or EBIAT. (Generally speaking, using EBIAT will give the most conservative measure of interest coverage, and EBITDA will give the most liberal.)
What’s the Ideal Ratio?
While there’s no magic number when it comes to your business’s Interest Coverage Ratio, there are some general assumptions in terms of what investors and lenders are looking for. Generally speaking, you don’t want this ratio to be lower than 1.5—and even 2.5 can be cause for concern. However, there can be exceptions to this guideline based on the industry you’re in. In the case of larger companies in more established industries like utilities, an interest coverage ratio of 2 might actually be sufficient, since their revenues are more reliable.
As a small business owner, the higher your interest coverage ratio, the better. If the ratio slips below 1.0, this raises a red flag that you are seriously risking dipping into your cash reserves to cover your interest payments, which could lead to consequences as serious as bankruptcy.
Any savvy investor or lender will be looking at your Interest Coverage Ratio over time and not just for one period. While looking at the ratio for any given period gives a good snapshot of your company’s short-term financial health, a much clearer picture is achieved by looking at fluctuations in the Interest Coverage Ratio over time: is the ratio getting worse, improving, or remaining stable? Investors will be asking these questions to determine the likelihood that your business will stay afloat, pay off its interest payments, and grow. It’s also worth your while to look at this metric on your own in order to get a handle on your company’s current financial standing and future trajectory.