Interest coverage

In simple terms

Interest must be paid whether a company has a good year or a bad one. Interest coverage shows how comfortably profits can meet that bill.

A coverage of 6 times means operating profit could pay the interest six times over. A coverage of 1.5 times means a modest fall in profit would leave the company unable to pay interest from its earnings.

Why coverage can collapse

Interest is a fixed cost, so coverage falls faster than profit. This is a form of financial leverage, adding to the operating leverage many businesses already have.

That is why analysts look at coverage in the worst year of a past downturn, not just the latest year, especially for cyclical businesses.

Variations on coverage

EBITDA coverage uses EBITDA instead of EBIT. It is higher, because depreciation is added back, and closer to operating cash earnings. But depreciation reflects assets that must eventually be replaced, so EBIT coverage is the more cautious measure.

Cash coverage uses operating cash flow before interest. It checks that interest is covered by cash, not just by accounting profit, which matters when earnings quality is weak.

Debt service coverage compares cash available with interest plus scheduled loan repayments due in the year. Lenders often use it for project companies, such as power plants and roads, where loans are repaid in instalments.

Refinancing risk

Many companies do not repay loans from earnings; they replace old loans with new ones as they fall due. This works when lenders are willing. Refinancing risk is the danger that a large loan falls due at a time when lenders are cautious, rates are high, or the company's results are weak.

The borrowings note in the annual report shows when loans mature and at what rates. Warning signs include:

• A large share of debt due within a year, especially if funded by short-term instruments such as commercial paper.
• Short-term borrowing used to fund long-term assets, which must be rolled over repeatedly.
• Floating-rate debt when interest rates may rise.
• Rising interest rates on new borrowing, which can signal lenders' growing concern.

What counts as comfortable?

There is no single safe level. Many analysts are cautious when EBIT coverage falls below about 3 times for an ordinary industrial company, and more cautious still for a cyclical one. Utilities and other businesses with steady, contracted income can operate safely with lower coverage. As with debt ratios, compare with peers and with the company's own history, and test a bad year.

Why it matters

Companies rarely fail because their debt-to-equity ratio is high; they fail because they cannot pay interest or repay a loan when it falls due. Coverage and the maturity profile tell you how much room a company has before that happens. For shareholders, a company that runs out of room may have to issue shares cheaply or hand control to lenders.

Limitations

Coverage uses one year's profit, which may be unusually high or low. Interest expense in the income statement can be reduced by capitalising interest on projects under construction, which makes coverage look better; check the notes for capitalised interest. And coverage says nothing about when loans must be repaid, which is why the maturity profile matters too.

Common mistakes

• Judging coverage only in a good year.
• Ignoring capitalised interest, which hides part of the true interest cost.
• Ignoring loan repayments, which also need cash.
• Overlooking debt due soon, however good coverage looks.

Try it yourself

Choose a listed company with significant borrowings.

1. Calculate EBIT coverage for each of the last five years, including any weak year.
2. Check the notes for interest capitalised during the year and recalculate coverage including it.
3. From the borrowings note, list how much debt falls due in the next year and the next five years.
4. Write a sentence on how much EBIT would need to fall before coverage dropped below 2 times.