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.