Formula
Interest Coverage Ratio = EBIT ÷ Interest Expense
The Short Version
Beyond the debt-to-equity ratio covered in the Stock Market guide, analysts check whether a company generates enough operating profit to comfortably cover its interest payments — a direct test of debt sustainability.
Explain It Like I'm 10
Imagine your allowance is $40 a month, and you have to pay $8 a month toward a bike loan from your parents. You could cover that payment 5 times over with your allowance ($40 ÷ $8 = 5) — plenty of cushion. But if your loan payment were suddenly $35 a month, you'd barely be able to cover it (just over 1×), and any surprise expense could put you in real trouble.
Step-by-Step Example
- 1 EBIT (operating profit): $40,000,000.
- 2 Annual interest expense on debt: $8,000,000.
- 3 Interest Coverage Ratio = $40,000,000 ÷ $8,000,000 = 5.0×.
- 4 A company earns 5 times what it needs just to cover its interest payments — a comfortable cushion.
- 5 If that ratio fell to 1.2×, the company would barely be covering its interest with operating profit, leaving very little room for a bad quarter — a real red flag for financial distress risk.
Textbook Example
A company with $40 million in EBIT and $8 million in annual interest expense has an interest coverage ratio of 5.0x.
Quick Recap
- ✓ A higher ratio means more of a cushion — the company earns several times its interest obligation.
- ✓ A ratio below roughly 1.5x is often viewed as a warning sign of financial distress risk.