Below 1.5x - danger
Operating profit barely covers interest. A downturn or rate rise directly threatens solvency.
Definition
What is the interest coverage ratio?
The interest coverage ratio is operating profit (EBIT) divided by interest expense. It tells you how many times over a company's earnings can pay the interest on its debt. A ratio of 5x means EBIT is five times the annual interest bill - a comfortable cushion; a ratio near 1x means almost all operating profit is consumed by lenders.
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Short answer
Interest coverage is the fastest read on whether debt is dangerous. Above ~3-4x is generally safe; below ~1.5x and a single bad year can mean the company can't pay its lenders. It's a core input to distress models like the Altman Z-Score.
How to read interest coverage
1.5-3x - watch
Manageable in good times, fragile in a downturn. Elevated risk for cyclical businesses.
3-6x - healthy
A comfortable cushion for most businesses; debt is being serviced from operations with room to spare.
Above 6x - strong
Debt is easily serviced. Little near-term solvency risk arising from leverage.
How fast a cushion can disappear
A company with $600M of EBIT and $100M of interest expense covers its interest 6 times over - very safe. Even if EBIT halved in a recession, coverage would still be a comfortable 3x.
A peer with $150M of EBIT against the same $100M of interest covers it just 1.5x. The same recession-driven halving of EBIT would push coverage below 1x - meaning operating profit no longer covers the interest bill at all, and the company must dip into cash or refinance to stay current.
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Related
- What is the debt-to-equity ratio? - the leverage level; interest coverage shows whether that leverage is affordable.
- What is the Altman Z-Score? - the distress model that uses earnings-to-debt-service signals like this one.
- What is EBITDA? - the earnings measure (and its caveats) behind coverage ratios.
See whether the debt is affordable
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