Interest Coverage Ratio: Formula & Examples

What is the Interest Coverage Ratio?

The interest coverage ratio is a financial ratio used to determine a company’s ability to meet its interest expense obligations with its operating income. Analysts, lenders, creditors, and investors may be interested in calculating the interest coverage ratio– in addition to several other financial ratios– to assess a company’s financial strength. It is calculated by dividing the company’s operating income by its interest expense. The result is often depicted as a number.

What is a Good Interest Coverage Ratio?

A good interest coverage ratio is 3.0 or more. Analysts view an interest coverage ratio of less than 3.0 as a negative sign. If a company’s interest coverage ratio is less than 3.0, it may not be able to pay its interest expense with its current operating income. The company may be forced to find other sources, such as retained earnings from prior years, to cover interest expenses. It does not bode well for the company’s ability to meet its financial obligations and continue in existence.

On the other hand, an interest coverage ratio of more than 3.0 indicates that the company is able to pay its accumulated interest with its current operating income. Some lenders require that a company keep an interest coverage ratio of greater than 3.0. If that is the case, the requirement would typically be included as part of the debt covenant– a set of conditions and restrictions attached to the lending agreement.

What is the Formula for Interest Coverage Ratio?

The formula for interest coverage ratio is:

Interest Coverage Ratio = Operating Income / Interest Expense

OR

Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

Although operating income and Earnings Before Interest and Taxes (EBIT) are used interchangeably, there may be slight differences as EBIT includes interest income while operating income excludes it.

What are the Components of Interest Coverage Ratio?

The interest coverage ratio is easy to calculate because its components are readily identifiable. Operating income and interest expense can both be found on a company’s income statement.

Operating income

Operating income is a company’s revenue minus cost of goods sold (COGS) and operating expenses. It excludes interest income and other income from sources outside its day-to-day operations. Operating expenses include all expenses that are incurred in day-to-day operations. They exclude interest expense and income taxes– as those are unrelated to the core business’s operations. Examples of operating expenses include:

• Selling, General, and Administrative (SG&A) expenses
• Depreciation
• Amortization

EBIT

Operating income is sometimes referred to as earnings before interest and taxes (EBIT). However, EBIT is not an approved financial measure by Generally Accepted Accounting Principles (GAAP)– it is not allowed on an income statement. Operating income does appear on the income statement, so it is an easier figure to identify and calculate the interest coverage ratio. There may be slight differences between operating income and EBIT because EBIT includes interest income while operating income excludes it.

Interest Expense

Interest expense is the cost of borrowing money from a lender. Interest expense arises from debt financing. It is a non-operating expense because it is not incurred in the company’s direct line of business. It is typically calculated as a percentage of the outstanding principal balance of the debt. Interest expense is added to the initial amount borrowed by the company to arrive at the total amount due to the lender. The following items typically carry an interest expense:

• Loans
• Credit Cards
• Lines of Credit
• Bonds
• Finance Leases

Example of Interest Coverage Ratio

Assume ABC Company has $10,000 in annual interest expense. If its operating income is $120,000, it has an interest coverage ratio of 12x. This is a positive sign that the company will have no problems covering its interest expenses with its operating income.

Interest Coverage Ratio = $120,000 / $10,000 = 12

Where:

• $120,000 = Operating Income
• $10,000 = Interest Expense

Alternatively, assume ABC Company had only $20,000 in operating income, its interest coverage ratio would be 2.0. The ratio is lower than the standard of 3.0, which would indicate to analysts that ABC may have trouble paying its interest expense obligations on its current operating income.

Interest Coverage Ratio = $20,000 / $10,000 = 2.0

Where:

• $20,000 = Operating Income
• $10,000 = Interest Expense

Real Company Example: Walmart’s Interest Coverage Ratio

Walmart’s Annual Report, Form 10-K for the year ended January 31, 2023, included this consolidated income statement. The company presents its operating income and net interest expense on the financial statement. The net interest expense is the combination of its interest income– interest it has earned from investors– and its interest expense– amounts it has paid to lenders.

Walmart lists an operating income of $20.428 billion in 2023 and $25.942 billion in 2022. For net interest, it has $1.874 billion in 2023– broken down further to $1.787 billion in debt interest expense, $341 million in finance lease interest expense, and $254 million in interest income. In 2022, those figures were: net interest of $1.836 billion, $1.674 billion in debt interest expense, $320 million in finance lease interest expense, and $158 million in interest income.

Using these figures, you could calculate Walmart’s 2023 interest coverage ratio at:

$20.428 billion / $1.874 billion = 10.9

Where:

• $20.428 billion = operating income
• $1.874 billion = net interest

By calculating EBIT– removing interest income from the net income figure and adding it to the operating income figure– you could calculate Walmart’s 2023 interest coverage ratio as:

($20.428 billion + $254 million) / ($1.787 billion + $341 million) = 9.7

Where:

• $20.428 billion = operating income
• $254 million = interest income
• $1.787 billion = debt interest expense
• $341 million = finance lease interest expense

The ratio is considerably higher than the standard minimum of 3.0. Analysts would consider this a positive indicator. It is unlikely that Walmart would be unable to cover its current interest expense with its operating income.

The Benefit of the Interest Coverage Ratio Year-Over-Year

You can use the interest coverage ratio, in addition to other key performance indicators, to give an understanding of how a company is doing year-over year. That is, how well a company is performing financially in comparison to the prior year. Using the Walmart example, we can calculate its 2022 interest coverage ratio as follows:

$25.942 billion / $1.836 billion = 14.1

Where:

• $25.942 billion = operating income
• $1.836 billion = net interest

Using the EBIT calculation:

($25.942 billion + $158 million) / ($1.674 billion + $320 million) = 13.1

Where:

• $25.942 billion = operating income
• $158 million = interest income
• $1.674 billion = debt interest expense
• $320 million = finance lease interest expense

In both of these ratios, the 2022 numbers are higher than the 2023 numbers– 14.1 and 13.1 versus 10.9 and 9.7, respectively. This is due to Walmart’s higher operating income and lower interest expense in 2022. It shows a negative trend, and it would be something analysts would like to keep an eye on in the future. Both years’ ratios meet the minimum standard and are greater than 3.0, so it does not represent an immediate concern.

Additional Resources

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