Interest Coverage also known as Times Interest Earned (TIE) Ratio is an excellent metric to evaluate a company’s ability to service its debt obligations from operating income. It is most insightful when analyzing companies with high debt to equity ratios. Debt levels vary substantially across industries – capital-intensive sectors like construction, infrastructure, and renewables tend to sustain higher debt to equity ratios than technology companies. In high-leverage cases, Interest Coverage is a vital ratio to gauge if a company can meet interest expenses in a sustainable manner.
The Interest Coverage ratio is defined as: Interest Coverage Ratio = EBIT / Interest Expense
Where EBIT (Earnings Before Interest and Taxes) comes from the income statement:
EBIT = Revenue – Cost of Goods Sold – Operating Expenses
For example, consider a company with the following simplified income statement:
Revenue: $1234 million
Cost of Revenue: $1000 million
Gross Profit: $234 million
Operating Expenses: $160 million
Operating Income (EBIT): $74 million
Interest Expense: $20 million
This company’s Interest Coverage ratio is EBIT of $74 million / Interest Expense of $20 million = 3.7x
Although 3.7x shows the company is sufficient in managing its debt obligations, more analysis needs to be done example its future growth of earnings, mean or medium interest coverage of the sector that company operates in. Keeping other factors constant, if comparing two peer companies, the company with higher interest coverage would be preferred. The higher the ratio, the more comfortably a company can fund interest owed from operational earnings. A ratio above 1.0x means a company earns greater operating profits than interest owed. Below 1.0x indicates paying more in interest than the company earns, which is unsustainable long-term. While a useful indicator, Interest Coverage is one of several metrics to assess balance sheet health. Analysts also use EBITDA Interest Coverage. You need to add depreciation and amortization back to EBIT to calculate this ratio.
The Price to Free Cash Flow ratio is another key measure of corporate financial strength.
The brief course on Introduction to Valuation covers Interest Coverage as a measure. Feel free to subscribe to monthly or yearly subscription. Subscription package includes all reads including instructional reads and selected online courses. A special pricing offering from The middle Road.
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