What Is a Good Interest Coverage Ratio?

The interest coverage ratio measures a company's ability to handle its outstanding debt. It is one of a number of debt ratios that can be used to evaluate a company's financial condition. A good interest coverage ratio is considered important by both market analysts and investors, since a company cannot grow—and may not even be able to survive—unless it can pay the interest on its existing obligations to creditors.

KEY TAKEAWAYS

A company's interest coverage ratio determines whether it can pay off its debts.

The ratio is calculated by dividing EBIT by the company's interest expense—the higher the ratio, the more poised it is to pay its debts.

Creditors can use the ratio to decide whether they will lend to the company.

A lower ratio may be unattractive to investors because it may mean the company is not poised for growth.

Interpreting the Interest Coverage Ratio

If a company has a low-interest coverage ratio, there's a greater chance the company won't be able to service its debt, putting it at risk of bankruptcy. In other words, a low-interest coverage ratio means there is a low amount of profits available to meet the interest expense on the debt. Also, if the company has variable-rate debt, the interest expense will rise in a rising interest rate environment. 

A high ratio indicates there are enough profits available to service the debt, but it may also mean the company is not using its debt properly. For example, if a company is not borrowing enough, it may not be investing in new products and technologies to stay ahead of the competition in the long-term. 

Optimal Interest Coverage Ratio

What constitutes a good interest coverage varies not only between industries but also between companies in the same industry. Generally, an interest coverage ratio of at least two (2) is considered the minimum acceptable amount for a company that has solid, consistent revenues. Analysts prefer to see a coverage ratio of three (3) or better. In contrast, a coverage ratio below one (1) indicates a company cannot meet its current interest payment obligations and, therefore, is not in good financial health.

Importance of Interest Coverage Ratio

This is an important figure not only for creditors, but also for shareholders and investors alike. Creditors want to know a company will be able to pay back its debt. If it has trouble doing so, there's less of a likelihood that future creditors will want to extend it any credit.

Similarly, both shareholders and investors can also use this ratio to make decisions about their investments. A company that can't pay back its debt means it will not grow. Most investors may not want to put their money into a company that isn't financially sound.