Definition of Interest Coverage Ratio
The interest coverage ratio is a financial ratio used as an indicator of a company's ability to pay the interest on its debt. (The required principal payments are not included in the calculation.) The interest coverage ratio is also known as the times interest earned ratio.
The interest coverage ratio is computed by dividing 1) a corporation's annual income before interest and income tax expenses, by 2) its annual interest expense.
A large interest coverage ratio indicates that a corporation will be able to pay the interest on its debt even if its earnings were to decrease. A small interest coverage ratio sends a caution signal.
Example of Interest Coverage Ratio
Assume a corporation's most recent annual income statement reported the following:
- Net income after tax of $650,000
- Interest expense of $150,000
- Income tax expense of $100,000
Based on the above amounts, the corporation's annual income before interest and income tax expenses is $900,000 (net income of $650,000 + interest expense of $150,000 + income tax expense of $100,000). Therefore, corporation's interest coverage ratio is 6 or 6 times ($900,000 divided by the interest expense of $150,000).
Since the interest coverage ratio is based on the net income under the accrual method of accounting, we recommend that you also review the corporation's cash provided by operating activities (which is found on its statement of cash flows) for the same time period.