Deals & Acquisitions
Feb 20, 2023
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This guide explains what interest coverage is and why it’s important. We also cover how interest coverage is calculated and how lenders use ratios to gain insight into a business’ ability to repay debt. Here are some key takeaways about interest coverage:
Interest coverage is a concept in corporate finance concerning a business’ ability to pay interest on outstanding debt.
Lenders use the interest coverage ratio (among other things) to help determine how easily a borrower can make payments on the money they are considering lending.
When a business needs money for growth but doesn’t have the ability to pay for that growth out of cash flow, it will look to use either debt or equity to finance its operational expansion. To learn more about the decision to use debt vs equity, we recommend: Capital Stack Quick Guide.
Interest coverage looks at how a business looking to borrow money to finance that growth—specifically with debt—would be able to repay the loan. To learn more about how businesses use loans, we recommend our guide: Term Loans (Part 1): How They Work.
So, if interest coverage is a concept that lenders use to judge a business’ ability to pay interest on the money they want to borrow, how do lenders determine a business’ ability to pay?
Now that we understand what interest coverage is, we’ll look at how interest coverage is calculated. Lenders use the interest coverage ratio in an attempt to quantify a business’ ability to pay back interest. The interest coverage ratio is also sometimes called the “times interest earned” ratio.
The interest coverage ratio uses data from the income statement to measure a business’ use of financial leverage. This ratio tells a lender the extent to which a business’ current earnings are able to handle interest payments. See the infographic below for how interest coverage is typically calculated.
EBIT stands for earnings before interest and taxes. We use EBIT as a metric because the business will make interest payments out of operating income. Interest Expense is the interest portion on the loan the business will be repaying.
The interest coverage ratio gives lenders a specific number. This number can be used for comparative purposes and is indicative of a business’ ability to pay interest out of operating income.
As a side note, EBIT is most commonly used in the interest coverage ratio, but lenders can use other financial information to calculate interest coverage ratios, based on what makes sense for the particular business they’re considering lending to. A variation on this could be EBITDA/Interest Expense. This formula would take into account depreciation and amortization as well.
A simple way to understand a company’s ability to make interest payments is the lower the interest coverage ratio, the greater the chance the company will not be able to pay back the loan. In other words, the higher the interest coverage ratio, the better, although there are ideal interest coverage ratios by industry, taking into account the nature of doing business in various ways.
Lenders use the interest coverage ratio to determine the risk in lending to a business based on its current debt.
The reason the interest coverage ratio is sometimes called the “times interest earned” ratio is because the ratio shows a lender how many “times” a company can pay back its debt based on its earnings.
The lower the ratio is, the more burdened by debt the business is—and the lower the ratio, the less cash flow the business has to invest in other ways.
Lenders typically look at average interest coverage ratios in the industry the business operates in to help determine what is a “good” ratio.
However, for general guidance, normally an interest coverage ratio of 2 is considered the lowest acceptable, provided the company has consistent cash flow. In some industries 1.5 is considered the minimum acceptable to lenders. An interest coverage of 3 or higher is considered optimal to lenders in most cases. When the interest coverage ratio is below 1, the viability of the business’ operations is called into question because the failure to make interest payments will result in bankruptcy.
Again, to summarize: a higher interest coverage ratio is a good thing, indicating a stronger ability to repay; and a lower interest coverage ratio is considered worse, as it indicates the business has less resources available to make payments on outstanding debt.
Lenders also don’t just look at interest coverage ratios for one year, they prefer to look at financial data over a longer period of time. This gives a better picture of a business’ ability to pay and gives insight into how the company has historically managed cash flow and debt.
In the event that a lender had a lower interest coverage ratio, but still appeared to be able to pay interest on the loan, lenders may look to secure the debt. Secured debt is debt where assets are put up as collateral. Securing loans with assets, such as real estate, makes the lender’s loan more secure. To learn more about secured vs unsecured loans, we recommend our guide: Term Loans (Part 2): Structure & Amortization.
