The formula
The interest coverage ratio is the lender’s question in one number: does this business earn enough to pay its interest, before tax, before principal, before anything else. Take the business’s EBIT — earnings before interest and taxes — and divide it by its interest expense, what it owes in interest. A ratio of 4.00 means the business earns $4.00 for every $1.00 of interest it owes. This guide works it in seven steps.
Step 1 — Find the EBIT
Start with the earnings before interest and taxes: take the revenue, subtract the operating expenses — rent, wages, materials, the cost of running the business — and add the interest and the tax back. That is the EBIT. On the worked example the EBIT is $480,000.00.
Step 2 — Find the interest expense
Now find what the business owes in interest: the interest on its loans, its credit lines and its bonds, over the same period as the EBIT. Do not include principal repayments — only the interest goes here. On the worked example the interest expense is $120,000.00.
Step 3 — Divide the EBIT by the interest expense
Divide the EBIT by the interest expense. That is the interest coverage ratio. On the worked example it is $480,000.00 ÷ $120,000.00 = 4.00. The business earns four times what it owes in interest — earnings cover interest four times over.
Step 4 — Work out the EBIT the target needs
Multiply the target ratio by the interest expense, then subtract the EBIT, to find the EBIT the business must earn. On the worked example the target is 3.00, so the EBIT needed is 3.00 × $120,000.00 − $480,000.00 = $0.00 — the EBIT is already $120,000.00 above the $360,000.00 needed.
Step 5 — Work out the most interest expense the target allows
Divide the EBIT by the target ratio to find the most interest expense the target allows. On the worked example it is $480,000.00 ÷ 3.00 = $160,000.00. At the 2.00 target it is $480,000.00 ÷ 2.00 = $240,000.00.
Step 6 — Check the result against the 3.00 lenders want
Compare the ratio with the 3.00 lenders generally look for: on the worked example the ratio is 4.00, so the business clears the bar with $120,000.00 of headroom — it could lose $120,000.00 of earnings and still hit 3.00.
Step 7 — Check the result against the 1.00 floor
Compare the ratio with 1.00: at 1.00 the earnings exactly cover the interest and nothing is left — on the worked example that would mean interest expense of $480,000.00. Below 1.00 the earnings do not cover the interest at all, and the business must dip into cash or reserves to pay its lenders. One warning: the reverses are judged on the UNROUNDED ratio — at $359,999 the EBIT is $1 short of the $360,000 needed, and the unrounded ratio is 2.999991 approximately, shown as 3.00 only after rounding.
Three worked examples
The headline example: $480,000.00 of EBIT and $120,000.00 of interest expense. The ratio is $480,000.00 ÷ $120,000.00 = 4.00, the EBIT needed at the 3.00 target is $0.00 — already $120,000.00 above the $360,000.00 needed — and the most interest expense allowed at 3.00 is $160,000.00. Interest expense of $160,000.00 instead: the ratio is 3.00 — exactly at the target. EBIT of $360,000.00 instead: the ratio is 3.00 — exactly at the target. Use the interest coverage ratio calculator for your own numbers.
Two reverses to check your answer
The smallest whole-dollar EBIT for the ratio to reach 3.00 is $360,000 — at $360,000 the ratio is 3.00, and at $359,999 the EBIT is $1 short of the $360,000 needed. The largest whole-dollar interest expense for the ratio to STAY at or above 3.00 is $160,000 — at $160,000 the ratio is 3.00, and at $160,001 the interest expense is $1 over the $160,000 allowed.
What EBIT is, and what it is not
EBIT is earnings before interest and taxes: revenue minus operating expenses, with interest and tax added back. It is the earnings the business makes from running the business, before the lenders and the tax office take their cut. What it is not: it is not the profit after tax, and it is not the cash flow. A business can report strong EBIT and still be short of cash, because EBIT counts sales it has not yet collected.
Why lenders want 3.00 or higher
A lender wants 3.00 or higher because earnings move: a bad quarter, a lost customer, a price rise in materials, and the ratio falls. At 4.00 the business can lose a quarter of its earnings and still cover its interest; at 1.50 it can lose only a third before it is short. Below 1.50 the lender looks closer, and may write a covenant into the loan — a promise to keep the ratio above a line.
What to do below target
A ratio below target means the business earns less than the target times its interest expense. If the ratio were 2.00 instead, the business would be inside the acceptable band but below what lenders want. The fixes are the formula’s two levers: raise the EBIT, or cut the interest expense. Raise prices, cut operating costs, or pay down the debt that carries the interest. The smallest whole-dollar EBIT that reaches 3.00 is $360,000 — at $359,999 the EBIT is $1 short of the $360,000 needed.
What a ratio above 3.00 means
A ratio above 3.00 does not mean four times as safe — it may mean the business is under-leveraged, not using cheap debt to grow. On $600,000.00 of EBIT and $120,000.00 of interest expense the ratio is 5.00 and the most interest expense a 3.00 ratio allows is $200,000.00. The 3.00 target is the line for covering the interest with room to spare; above it, the question is whether the business should borrow more to grow faster.
How the interest coverage ratio differs from the debt-service coverage ratio and the liquidity ratios
The debt-service coverage ratio counts principal repayments too: it asks whether the earnings cover the interest plus the principal, so it is always the stricter test. The liquidity ratios — current, quick and cash — ask a different question: whether the business can pay its short-term bills from what it holds, not whether its earnings cover its interest. The current ratio counts everything the business can turn into cash within a year; the quick ratio takes the inventory out; the cash ratio takes the receivables out too. The interest coverage ratio is the earnings test; the liquidity ratios are the balance-sheet test.