Interest Coverage Ratio

The interest coverage ratio, also called the times interest earned ratio, compares the funds available to pay interest (earnings before interest and taxes) with the amount of interest expense on the income statement. Interest expense on the income statement includes interest expense on debt obligations and on finance leases .

The Interest Coverage Ratio gives an indication of how much earnings the company has available for the payment of its fixed interest expense. Earnings before interest and taxes is used in the numerator because interest is a tax-deductible expense. Therefore, pre-tax earnings can be used to pay interest.

A high interest coverage ratio is desirable. An interest coverage ratio of greater than 3 is excellent. When the interest coverage ratio gets down to 1.5 , the company has a heightened risk of default. The further the ratio declines below 1.5, the higher the risk of default becomes.

However, the interest coverage ratio is a simplified measure because it does not include obligations for operating and short-term lease payments in the denominator, nor does it add back expensed operating and short-term lease payments to the numerator. The interest coverage ratio also does not include in the denominator required principal repayments on debt or required lease liability (principal) payments on finance leases.