How interest coverage works

Lenders ask whether operating profit covers the interest. Divide EBIT by interest expense and the answer is a multiple:

$$\text{Coverage} = \frac{\text{EBIT}}{\text{Interest}}$$

EBIT is operating profit before interest and tax. Interest is the period's interest expense. The ratio is a multiple: 8, not 8 percent.

On $80,000,000 of EBIT against $10,000,000 of interest, coverage is 8 times. The operations earned the interest bill eight times over. Eight times is a comfortable teaching-sheet reading. It is not a covenant. Loan agreements write their own tests, often on EBITDA rather than EBIT, and often with add-backs this page does not run.

This is a cousin of the leverage ratio family: those ratios are stocks on a balance sheet. Coverage is a flow on an income statement. A firm can look modestly borrowed on the sheet and still fail coverage if EBIT has fallen. The interest coverage calculator on this page is the one division.

Keep EBIT at $80,000,000 and raise interest to $20,000,000. Coverage falls to 4 times. Profit did not fall. The bill did.

That is the rate-reset case in one line. Floating-rate debt that rolls into a higher coupon does this without any new borrowing. The leverage ratios on the balance sheet may not have moved at all.

EBIT is now $40,000,000, interest still $10,000,000. Coverage is 4 times, matching the second sheet by a different route. The first cut the denominator. This one cut the numerator.

A cyclical firm at the bottom of its cycle prints the ugly coverage reading just when it would most like to borrow. That is why coverage is tested in a downturn in a credit memo, not only on last year's peak EBIT. EBITDA sits one line above EBIT and will print a higher multiple for the same interest bill, which is why a lender who uses EBITDA is using a softer test.

Debt-to-equity, debt-to-assets and the equity multiplier are photographs of one date. Interest coverage is a film of a period. They can disagree without either being wrong.

A firm that borrowed years ago at a low fixed coupon can look heavy on the sheet and still cover interest many times. A firm that looks light on the sheet, with floating-rate debt and a bad year of EBIT, can print 4 times coverage from either of the two routes above. Read both families. Financial ratios explained puts coverage with leverage ratios in the four-family table, and flags the one reading that carries meaning with no comparable at all: below 1, the operating profit did not cover the interest bill.

Enterprise value over EBITDA is a valuation multiple, not a coverage test. Do not line 8 times coverage up next to 13 times EV/EBITDA and call the gap a finding. One asks whether this year's operations earned this year's bill. The other asks what buyers of the whole firm are paying for the operations.

It is not a covenant engine, not EBITDA coverage, and not a rating model. It will not print Infinity when interest is zero: a firm with no interest expense does not have infinite coverage, it has nothing to cover.

It is also not a recommendation about how much coverage a firm should keep. Eight times on the teaching sheet is $80,000,000 over $10,000,000. The second sheet doubles the bill to $20,000,000. The third halves EBIT to $40,000,000. For how much of the sheet is borrowed, use the leverage ratio page. This is educational material, not financial advice.