Interest cover ratio: how much borrowing a business can actually service

The formula

Interest cover equals operating profit divided by interest expense, expressed as a number of times. Cover of 5 means operating profit is five times the annual finance cost.

Why it matters more than gearing

Gearing measures the size of the debt. Interest cover measures the ability to carry it. A business can be heavily geared and perfectly safe if earnings comfortably absorb the interest, and lightly geared but fragile if they do not.

Thresholds in practice

• Above 4 times: generally comfortable, and most covenants are set below this.
• 2 to 4 times: manageable but sensitive to a downturn or a rate rise.
• Below 2 times: little room for error. A modest profit fall breaches typical covenants.
• Below 1: operating profit does not cover the interest at all.

Read it with cash, not just profit

Operating profit is an accruals figure. A business with strong profit but slow collections can breach an interest payment while its cover ratio still looks healthy. Pair interest cover with operating cash flow divided by interest paid and with a rolling cash flow forecast.

Rate sensitivity

Recalculate cover at a higher rate before signing new facilities. If a two point rise pushes cover from 3.2 to 1.8, the borrowing is priced for an environment that may not hold.

Data requirements

Interest cover needs an interest or finance cost account carrying a balance. Where finance costs are lumped into general overheads, the ratio cannot be computed honestly. NanoFora identifies interest accounts in the ledger, shows the operating profit and interest figures used, and reports the ratio as not calculable when no finance cost is posted. See also debt ratio and debt-to-equity.