interest coverage ratio

Also called times interest earned, the interest coverage ratio measures a company’s ability to pay interest on its outstanding debt. The formula is earnings before interest and taxes divided by interest expense for the same period. Because interest on debt must be paid, regardless of cash flow, a higher number indicates a healthy firm. A ratio below 1.0 indicates that the company is not generating enough earnings to pay its interest obligations. Creditors look at this ratio to gauge the likelihood of payment if the company runs into financial trouble. Bond investors use this ratio to judge how risky the debt might be. For shareholders, a low number can mean that a company may not be able to pay its interest and may default on a loan, which may force the firm to sell assets or businesses or to file for bankruptcy. Each of these issues will affect a company’s share price.