What is the interest coverage ratio?

Definition

The interest coverage ratio is operating income divided by interest expense. On the books, this is an earnings coverage reading on the Income Statement, not a ledger account and not a cash test of the full loan payment.

A regional HVAC shop uses it when an equipment loan is on the books. The question is how many times core profit covers the interest bill, not whether principal was paid down.

A result of 6.0 means operating earnings are six times the interest for the period. A result below one means operations did not earn enough to cover interest.

Stay with earnings against interest when you read it. Cash against principal plus interest is a different page.

Where it shows up

P&L: Related to operating income against interest expense.

Cash flow: Related to whether that coverage is actually cash.

Balance Sheet: Related to the debt producing the interest.

See also: Interest Expense · Operating Income · Covenant

When you look at your Income Statement, take operating income, then divide by interest expense. Operating income is profit from core work before interest and taxes.

When the reading is high, core profit covers the interest bill with room. When it is low or below one, the shop is relying on non-operating items, savings, or new borrowing to carry the interest.

The Balance Sheet does not print this ratio. It holds the notes payable that produce the interest.

On the Statement of Cash Flows, interest paid is often an operating cash event. This page stays on the earnings version of coverage, which can differ from cash if invoices are still open.

How it works

Start with operating income for the period. That line is after operating costs and before interest and taxes.

Divide by interest expense for the same period. Use the interest that posted, not the full loan payment.

$48,000 of operating income against $8,000 of interest is 6.0. The $8,000 is the interest piece only.

Some readers use EBITDA in the numerator instead. That version adds back depreciation expense and amortization, so the reading is usually higher.

Stay with interest in the denominator. Putting principal in as well turns this into a cash coverage test of the whole payment, which is a different page.

Some lenders write a floor into a covenant. Missing that floor can put the equipment loan in default even if the trucks are booked.

Do not treat a high leftover profit as proof this reading is fine. Net income is after interest, so it already subtracted the bill this ratio is testing.

A shop with no interest expense does not have this ratio to compute. Coverage is a question that starts once borrowing is on the books.

Example

Valley Air HVAC, a regional shop, reports $48,000 of operating income for the year. Interest on its equipment loan is $8,000.

Divide: $48,000 by $8,000. The reading is 6.0.

The shop's full loan payment was larger because principal sat in it too. That larger payment is not this test.

If a slow season drops operating income to $6,000, the same $8,000 of interest reads 0.75. Operations did not earn the interest bill, even if cash in checking still covered the payment.

If the shop pays the note down and interest falls to $4,000, the original $48,000 of operating income reads 12.0. Core profit did not change; the interest bill got smaller.

The shop does not post a line that says this ratio. The Income Statement already holds operating income and interest expense; you divide.

A covenant that asks for 3.0 would be fine at 6.0 and would fail at 0.75. The floor is a contract test, not a printed account.

Common mix-ups

This ratio is not the same as debt service coverage. Debt service coverage uses cash against principal and interest together; this page uses operating earnings against interest only.

This ratio is not the same as the funding mix of debt against equity. That mix is a Balance Sheet reading; this page is an Income Statement coverage rate.

This ratio is not the same as cash in checking. Operating income can cover interest on paper while the related invoices are still unpaid.

Related terms

• Interest Expense: The cost of borrowing recorded for the period.
• Operating Income: Profit from core operations before interest and taxes.
• EBITDA: Earnings before interest, taxes, depreciation, and amortization.
• Covenant: A condition in a loan agreement the borrower must keep meeting.
• Debt Service Coverage Ratio: Cash available to cover scheduled principal and interest payments.
• Notes Payable: Formal loan balances owed to a bank or other lender.
• Debt-To-Equity Ratio: Total debt measured against owner equity.
• Income Statement: A statement showing revenue earned and expenses incurred over a period, ending in net income.