Interest Coverage Ratio

The interest coverage ratio (ICR), also called "times interest earned", is a measure of how many times a company's operating earnings cover its interest expense over a period. A ratio of 5 means the company earns five times what it pays in interest; a ratio below 1 means operating earnings do not cover interest at all. It is one of the most widely used tests of a company's ability to carry its debt.

Credit analysts, rating agencies and lenders use interest cover alongside leverage measures, and loan agreements often set a minimum level as a financial covenant. It differs from the debt service coverage ratio (DSCR), which adds scheduled principal repayments to the denominator. Interest cover therefore says whether a borrower can pay the running cost of its debt, while DSCR says whether it can also pay the debt down.

Imagine someone who has borrowed money and pays a fixed amount of interest every month. If their take-home pay is ten times that interest bill, a small pay cut barely matters. If their pay is only just above the interest bill, any setback means borrowing more just to keep up.

The interest coverage ratio asks the same question of a company: how many times over could this year's profits pay this year's interest? A high number means interest is a small burden. A number close to one means almost everything the business earns goes to its lenders, leaving little room for bad news.

The basic formula uses earnings before interest and tax:

• $\text{EBIT}$ is earnings before interest and tax, broadly operating profit from the income statement.
• $\text{Interest expense}$ is the interest charged on borrowings over the same period, sometimes net of interest income.

A manufacturer reports operating profit of 18 million and interest expense of 4 million. Its interest cover is 18 ÷ 4 = 4.5 times. If it refinanced 50 million of fixed-rate debt at a rate 3 percentage points higher, interest expense would rise by 1.5 million to 5.5 million and cover would fall to about 3.3 times, even with unchanged profits.

Common variants replace EBIT with EBITDA, which adds back depreciation and amortisation and gives a higher figure, or use a fixed-charge coverage ratio that adds lease payments to both the top and bottom of the fraction.

• Operating profit. Revenue growth, margins and cost control move the numerator, so a cyclical business sees its cover swing with the economy.
• Amount of debt. More borrowing raises interest expense, which is why interest cover falls after a leveraged buyout.
• Interest rates. Companies with floating debt feel rate rises straight away; those with fixed-rate bonds feel them only when they refinance. Hedging with an interest rate swap can smooth the effect, which is a core part of managing interest rate risk.
• Credit spreads. A weaker credit rating raises the margin a company pays over benchmark rates, reducing cover further.

There is no single safe level, because acceptable cover depends on how stable earnings are. Utilities with regulated income can operate on lower cover than technology or commodity firms. As a rough guide, cover in high single digits or above is typical of investment-grade bonds issuers, while leveraged borrowers that issue high-yield bonds often show cover of two to three times. Lenders set covenant floors with headroom below the borrower's forecast.

Interest cover is also used in macroeconomic analysis. The Bank for International Settlements has defined "zombie" firms as listed companies at least ten years old whose interest coverage ratio has been below one for at least three consecutive years. Studies using this measure found the share of such firms rose in advanced economies during the long period of low rates that followed the 2008 crisis, a period linked to zero interest-rate policy, and asked whether cheap credit kept weak businesses alive.

The ratio uses accounting profit, not cash, so a company can show good cover while struggling to collect receivables or fund capital spending. It ignores principal repayments, which can be large for a company facing a debt maturity, and it can flatter borrowers whose EBIT includes one-off gains. Definitions vary between lenders and data providers, particularly in how they treat leases, capitalised interest and interest income.

For these reasons analysts read interest cover together with leverage, the statement of cash flows and the maturity profile of the company's debt. A falling ratio is often an early sign of strain that leads to a request for a loan covenant waiver well before any payment is missed.

• Bank for International Settlements