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Home > QFINANCE Dictionary > Definition of interest cover

Definition of

interest cover

Finance

amount of money available for payment of interest the amount of earnings available to make interest payments after all operating and nonoperating income and expenses, except interest and income taxes, have been accounted for.

Interest cover is regarded as a measure of a company's creditworthiness because it shows how much income there is to cover interest payments on outstanding debt.

It is expressed as a ratio, comparing the funds available to pay interest (earnings before interest and taxes, or EBIT) with the interest expense. The basic formula is

EBIT / Interest expense = Interest coverage ratio

If interest expense for a year is $9 million, and the company's EBIT is $45 million, the interest coverage would be

45 million / 9 million = 5:1

The higher the number, the stronger a company is likely to be. A ratio of less than 1 indicates that a company is having problems generating enough cash flow to pay its interest expenses, and that either a modest decline in operating profits or a sudden rise in borrowing costs could eliminate profitability entirely. Ideally, interest coverage should at least exceed 1.5; in some sectors, 2.0 or higher is desirable.

Variations of this basic formula also exist. For example, there is:

(Operating cash flow + Interest + Taxes) / Interest = Cash flow interest coverage ratio

This ratio indicates the firm's ability to use its cash flow to satisfy its fixed financing obligations. Finally, there is the fixed-charge coverage ratio, that compares EBIT with fixed charges:

(EBIT + Lease expenses) / (Interest + Lease expenses) = Fixed-charge coverage ratio

"Fixed charges" can be interpreted in many ways, however. It could mean, for example, the funds that a company is obliged to set aside to retire debt, or dividends on preferred stock.

Recommended Further Reading (Term count)
  • Interest Coverage
    The amount of earnings available to make interest payments after all operating and nonoperating income and expenses—except interest and income taxes—have been accounted for.
  • Managing Interest Rate Risk
    by Will Spinney
    Almost all firms are exposed to interest rate risk, but it can manifest itself in different ways. A proper response to this risk can only come following a full understanding of the context of the firm and its strategy, along with a full evaluation of the risk. Firms should generate a well thought out key performance indicator (KPI) and then apply one or more of the many tools available in the market to transfer interest rate risk.
  • How Taxation Impacts on Liquidity Management
    by Martin O’Donovan
    Taxation is highly dependent on the specifics of the companies concerned and the tax jurisdictions to which they are subject. Nonetheless, there are sufficient structural similarities between countries so that background generalizations can be made, although the specific rules and tax rates vary over time and will need to be verified with local tax experts.Tax is initially assessed on the basis of each legal entity in isolation, but various...
interest cover - Related Articles
  • Managing Interest Rate Risk

    Best Practice

    A table can be constructed to show the effect on earnings and interest cover (Table 1). In the table items in bold represent the base case, whereas other columns represent the sensitivities to this base case. Earnings are earnings after interest and tax.
    By Will Spinney

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Definitions of ’interest cover’ and meaning of ’interest cover’ are from the book publication, QFINANCE – The Ultimate Resource, © 2009 Bloomsbury Information Ltd. Find definitions for ’interest cover’ and other financial terms with our online QFINANCE Financial Dictionary.

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