Interest Coverage Ratio
The interest coverage ratio is operating income divided by interest expense. It answers the lender’s first question, which should also be the shareholder’s: how many times over do current profits cover the annual cost of the debt?
The math
200 million dollars of operating income against 40 million of interest: coverage of 5 times. Now run the recession scenario.
Operating income falls 50 percent to 100 million and coverage drops to 2.5 times: uncomfortable but survivable. Start the same scenario at 2 times coverage and the company arrives at 1.0, where every operating dollar goes to lenders and one more bad quarter means missed payments, emergency refinancing, or dilution at the worst possible price.
| Strong start | Thin start | |
|---|---|---|
| Coverage today | 5.0x | 2.0x |
| After a 50% profit drop | 2.5x | 1.0x |
| Verdict | survivable | every dollar to lenders |
The trap
Judging coverage at the top of a cycle with rates locked in the past. The ratio is a snapshot: earnings are cyclical and interest costs reset when debt matures.
A company that borrowed cheaply years ago can show comfortable coverage today and see its interest bill double at refinancing. The maturity wall, when large debts come due, is where snapshots meet reality.
The move
Look for coverage above 5 times for industrial businesses, and treat anything under 3 as a risk that must be priced. Recompute the ratio with earnings from the last recession, not the last quarter.
And check the debt maturity schedule in the annual report: the size of what must be refinanced, and when, tells you whether today’s coverage will still exist in three years.