Interest cover is an affordability test. It compares the profit before tax (PBT) figure to interest charged in the profit and loss account.
If you plan to lend money to someone, you want to know they will be able to pay you back. The interest cover ratio (also known as the debt service ratio) is one way to measure the ability of a company to continue to meet its interest payments on any debt it has incurred.
The interest cover ratio matters to equity investors because shareholders are the last in the queue in terms of claims on assets if a company goes bust. If a company is struggling to repay its debts then any ongoing dividend payments are likely to come under threat as resources are diverted to repay creditors.
To calculate the ratio you simply take earnings before interest and tax (Ebit), or earnings before interest, tax, depreciation and amortisation (Ebitda), usually over a year, then divide by the interest costs incurred over the same period. The resulting ratio tells you how many times over a company could afford to pay the interest on its debts. For example, if a company has Ebit of £500,000, and interest costs of £250,000, then the interest cover ratio is two. The higher the ratio, the easier it is for the company to meet its repayments; a low ratio may well be a warning sign.
So what makes for a good interest cover ratio? A ratio of below one is clearly bad news it means the company's current earnings aren't sufficient to cover its interest payments. Otherwise, as with most financial ratios, it's worth comparing ratios with those of the peer group.
Companies with reliable, consistent cashflows such as utility companies, or big pharmaceutical groups should be able to sustain a higher level of debt because their revenues are more predictable. So a lower ratio might be fine here. Cyclical companies those whose business fluctuates with the fortunes of the economy and other companies with poorer revenue visibility (ie unpredictable sales) might only be able to safely sustain lower debts, so you would be looking for a higher ratio.