Interest coverage

The numerator is operating profit, not net profit, because net profit is calculated after interest has already been paid. To judge whether a company can afford its interest at all, you need the profit before interest.

How to read it

A coverage of 4 to 5 times is the minimum for comfort, and higher is better. Below 1.5 times suggests stress, and below 1 the company is not earning enough to pay its interest from operations. Read the trend over several years too: coverage that falls year after year is a warning even while the level still looks acceptable. Cyclical businesses need more cushion, because their profits can fall sharply in a bad year.

Why it matters even when debt is low

A company can have a D/E below 1 and still be unsafe if it earns little or no operating profit. A loss-making business cannot repay the bank, however little it has borrowed. That is why interest coverage and debt to equity belong together.

Related measures

Some analysts use EBITDA instead of EBIT, which gives a higher figure because depreciation is added back. The debt service coverage ratio (DSCR) goes further and adds principal repayments to the interest: below 1 means the company cannot service its debt from operations. Lenders often write a minimum interest coverage, such as 2.5 times, into their loan covenants.

Where to find it

Take operating profit from the profit and loss account and divide by finance costs, the interest line under Ind AS. Most research platforms calculate it, though on some it has to be added from a dropdown. The interest coverage formula page explains the reading in more detail.

Common mistakes

• Using net profit as the numerator, which counts interest twice.
• Relying on one year. The annual accounts arrive once a year, and short-term or working capital loans taken within the year may not show up. Check the quick ratio and the cash flow statement too.
• Ignoring capitalised interest. Interest on borrowings for assets under construction can be added to the cost of the asset instead of the P&L, which flatters coverage until the project is finished.

Questions investors ask

What is a good interest coverage ratio? At least 4 to 5 times for comfort. The more cyclical the business, the more cushion it needs.

What is the difference between interest coverage and DSCR? Interest coverage compares profit with interest alone; DSCR also includes the principal that must be repaid in the period.