Before you take out a large mortgage, a lender will usually try to find out at least two things. First, do you have any other borrowings; and second, can you afford the interest payments. If your salary is a sufficiently large multiple of interest payable each month, the chances are you will get the loan. The same is true of companies. Interest cover is an affordability test. It compares the profit before tax (PBT) figure to interest charged in the profit and loss account. So if PBT is £100m and interest is, say, £20m, interest cover is £100m/£20m, or five times. The higher the better.
Typically, this calculation is considered alongside the gearing ratio (the level of interest-bearing debt compared to shareholders’ funds in the balance sheet). The lower the better from a lender’s perspective. For a firm that is in danger of breaching its loan covenants on interest cover there are only limited choices. First, generate more profit. Second, reduce debt. Third, renegotiate terms. Or fourth – go bust.