Interest coverage ratio: can operating profit carry the interest?
The interest coverage ratio divides operating profit by interest expense, showing how many times a year's operating earnings cover that year's interest. Below 1, operating profit alone cannot pay the interest. It is one of the first figures a bank looks at when assessing a loan.
Formula
Interest coverage = operating profit ÷ interest expense
- Operating profit is profit from the core business. The textbook definition uses EBIT; Caveat uses operating profit.
- Interest expense is interest on borrowings, reported under non-operating expenses.
A ratio of 3 means operating profit is three times the interest bill, so a third of operating profit goes to interest.
Worked example
Figures in units of 100 million KRW. Operating profit is 3.2 and interest expense 0.3; the year before they were 2.1 and 0.3 (values calculated by the Caveat engine).
| Prior year | Current year | |
|---|---|---|
| Interest coverage | 6.18x | 10.67x |
Higher operating profit and lower interest after some repayment lifted the ratio from 6.18x to 10.67x. Check whether the numerator (profit) or the denominator (interest) moved to understand why.
How to read it
- Below 1: operating profit does not cover interest. The OECD treats firms aged ten years or more with a ratio below 1 for three consecutive years as zombie firms. Details vary by country (see the country notes below).
- Headroom above 1: a low ratio can drop below 1 after a small fall in sales or a small rise in rates. Working out how far operating profit could fall before the ratio hits 1 shows the margin of safety.
- Rate changes: with floating-rate loans, rising rates enlarge the denominator. Look at the size and terms of borrowings together.
Both sides: a high ratio is not purely good; the business may be passing up opportunities by not borrowing. A low ratio can be temporary right after a large investment that has not yet paid off. Look at the trend over several years and the timing of investment.
Look at these too
- Debt-to-equity ratio: how large the debt is relative to equity
- Operating cash flow: whether operating profit is turning into cash. Interest is paid in cash.
- Altman Z'-Score: a distress-risk signal combining several ratios
Limitations
- Operating profit is not cash. With growing receivables there may be too little cash to pay interest despite a profit.
- Principal repayments are not included. Borrowings with maturities bunched together can weigh more than the interest.
- Not calculated when there is no interest expense (no borrowings).
- For reference only; it does not replace credit, investment or tax decisions.
See it in your own statements
Upload a balance sheet and income statement and Caveat calculates these for your company.
FAQ
- What interest coverage ratio is safe?
- There is no fixed threshold. Below 1, operating profit does not cover interest; the higher the ratio, the more room to absorb falling profit or rising rates. Consider the industry, loan terms and the multi-year trend.
- What is a zombie company?
- A company whose operations have not earned enough to pay even its interest for several years running. The OECD defines it as a firm aged ten years or more with an interest coverage ratio below 1 for three consecutive years.
- What if operating profit is negative?
- The ratio becomes negative. The business is making an operating loss and paying all its interest from other sources.
- Which figures are needed?
- Operating profit and interest expense from the income statement.
Country notes: Korea
- How does Korea define marginal firms?
- The Bank of Korea and others classify companies with an interest coverage ratio below 1 for three consecutive years as marginal firms, usually without the OECD age condition.