# Interest Coverage Ratio: What It Is, Formula, and What It Means for Investors

> **Definition**
>
> The interest coverage ratio reveals a company’s solvency and ability to pay interest on its debt.

## What Is the Interest Coverage Ratio?

The interest coverage ratio is a debt and profitability ratio. It shows how easily a company can pay [interest](https://www.investopedia.com/terms/i/interest.asp) on its outstanding [debt](https://www.investopedia.com/terms/d/debt.asp). The ratio divides a company’s [earnings before interest and taxes (EBIT)](https://www.investopedia.com/terms/e/ebit.asp) by its interest expense over a specific period.

The interest coverage ratio may be called the [times interest earned (TIE) ratio](https://www.investopedia.com/terms/t/tie.asp). It helps lenders, investors, and creditors determine a company’s riskiness for future borrowing.

### Key Takeaways

*   The interest coverage ratio measures how well a company can pay the interest due on outstanding debt.
*   The ratio is found by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense during a given period.
*   The interest coverage ratio helps lenders, investors, and creditors determine a company’s riskiness for future borrowing.

![Interest Coverage Ratio](https://www.investopedia.com/thmb/k1GuHmwwANQQBRcdwZKmQ-iDuM4=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/interestcoverageratio-f7e7cdf96d4b4063a63d258ff5d775a8.jpg)

*A higher ICR suggest a stronger ability to pay interest and a lower risk of default. — Laura Porter / Investopedia*

## Formula and Calculation

  

$\begin{aligned} &\text{Interest Coverage Ratio}=\frac{\text{EBIT}}{\text{Interest Expense}}\\ &\textbf{where:}\\ &\text{EBIT}=\text{Earnings before interest and taxes} \end{aligned}$

The “coverage” represents the number of times a company can successfully [pay its obligations](https://www.investopedia.com/ask/answers/121814/what-good-interest-coverage-ratio.asp) with its earnings. A low ratio may signal that the company has high debt expenses with minimal capital. For example, when a company’s interest coverage ratio is 1.5 or lower, it can only cover its obligations a maximum of one and a half times. Its ability to meet interest expenses may be questionable in the long run.

Companies need earnings to cover interest payments and survive unforeseeable financial hardships. A company’s ability to meet its interest obligations is an aspect of its [solvency](https://www.investopedia.com/terms/s/solvency.asp) and a factor in the return for [shareholders](https://www.investopedia.com/terms/s/shareholder.asp).

> **Important**
>
> When corporate interest rates rise, interest coverage ratios may decline. Rising rates limit profits and hurt a company’s ability to borrow, invest, and hire new employees.

## Earnings Variations

*   **EBITDA**: Uses [earnings before interest, taxes, depreciation, and amortization (EBITDA)](https://www.investopedia.com/terms/e/ebitda.asp) instead of EBIT in calculating the interest coverage ratio. This variation excludes depreciation and amortization. Calculations using EBITDA produce a higher interest coverage ratio than calculations using EBIT.
*   **EBIAT**: Uses [earnings before interest after taxes (EBIAT)](https://www.investopedia.com/terms/e/ebiat.asp), deducting taxes from the numerator to render a more accurate picture of a company’s ability to pay its interest expenses.  
    

## What the Ratio Means for Investors

When a company struggles with its obligations, it may borrow or dip into its cash reserves, a source for [capital asset](https://www.investopedia.com/terms/c/capitalasset.asp) investment or required for emergencies. Analyzing interest coverage ratios over time will often give a clearer picture of a company’s position and trajectory.

Looking at a company’s ratios every quarter over many years lets investors know whether the ratio is improving, declining, or stable. Some banks or potential bond buyers may be comfortable with a less desirable ratio in exchange for charging the company a higher interest rate on their debt.

## Example

Suppose a company’s earnings for the first quarter are $625,000 with monthly debt payments of $30,000. To calculate the interest coverage ratio, convert the monthly interest payments into quarterly payments by multiplying by three.

The interest coverage ratio is $625,000 / $90,000 ($30,000 × 3) = 6.94. This indicates the company has no [liquidity](https://www.investopedia.com/terms/l/liquidity.asp) issues and can cover almost seven times its obligations.

An interest coverage ratio of 1.5 is low, and lenders may refuse to lend the company more money, as the company’s [risk of default](https://www.investopedia.com/terms/d/defaultrisk.asp) may be perceived as high. If a company’s ratio is below one, it will likely need to spend some of its [cash reserves](https://www.investopedia.com/terms/c/cash-reserves.asp) to meet the difference or borrow more.  

## What Are the Limitations of the Interest Coverage Ratio?

A company’s ratio should be evaluated against others in the same industry or those with similar [business models](https://www.investopedia.com/terms/b/businessmodel.asp) and [revenue](https://www.investopedia.com/terms/r/revenue.asp) numbers. However, companies may isolate or exclude certain types of debt in their interest coverage ratio calculations. As such, when considering a company’s self-published interest coverage ratio, determine if all debts are included.

## What Is a Good Interest Coverage Ratio?

A good ratio indicates that a company can service the interest on its debts using its earnings or has shown the ability to maintain revenues at a consistent level. A well-established utility will likely have consistent production and revenue due to government regulation. Even if it has a relatively low ratio, it may reliably cover its interest payments. Other industries, such as manufacturing, are much more volatile and may [often have a minimum acceptable interest coverage ratio](https://www.investopedia.com/ask/answers/030615/what-does-high-times-interest-earned-ratio-signify-regard-companys-future.asp) of three or higher.

## What Does an Interest Coverage Ratio of Less than One Indicate?

A poor interest coverage ratio, such as below one, means the company’s current earnings are insufficient to service its outstanding debt. The chances of a company being able to continue to meet its [interest expenses](https://www.investopedia.com/terms/i/interestexpense.asp) on an ongoing basis are doubtful.

## The Bottom Line

The interest coverage ratio, or times interest earned (TIE) ratio, shows how well a company can pay the interest on its debts. It is calculated by dividing EBIT, EBITDA, or EBIAT by a period’s interest expense. Interest coverage ratios vary across industries.  

> **Article Sources**
>
> 1.  Federal Reserve Bank of Boston. “[Interest Expenses, Coverage Ratio, and Firm Distress](https://www.bostonfed.org/publications/current-policy-perspectives/2023/interest-expenses-coverage-ratio-and-firm-distress.aspx).”