Advertisement

Interest cover

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.

Advertisement - Article continues below

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.

Advertisement
Advertisement

Recommended

Visit/glossary/601570/real-exchange-rate
Glossary

Real exchange rate

The real exchange rate between two currencies combines the nominal exchange rate with the ratio of the price of goods or services in two different cou…
26 Jun 2020
Visit/glossary/esg-investing
Glossary

ESG investing

ESG stands for environmental, social and corporate governance, the areas in which good behaviour is particularly sought.
19 Jun 2020
Visit/glossary/601496/faang-stocks
Glossary

FAANG stocks

The acronym FAANG refers to Facebook, Amazon, Apple, Netflix and Google (Alphabet) – five American companies that have been among the top-performing s…
12 Jun 2020
Visit/glossary/technical-analysis
Glossary

Technical analysis

Technical analysts or 'chartists' attempt to predict future share price (or index) movements by looking at past movements.
5 Jun 2020

Most Popular

Visit/investments/property/601606/house-prices-crash-uk-property-prices-falling-where-next
Property

House price crash: UK property prices are falling – so where next?

With UK property prices falling for the first time in eight years, are we about to see a house price crash? John Stepek looks at what’s behind the sli…
2 Jul 2020
Visit/economy/inflation/601584/the-end-of-the-bond-bull-market-and-the-return-of-inflation
Inflation

The end of the bond bull market and the return of inflation

Central bank stimulus, surging post-lockdown demand and the end of the 40-year bond bull market. It all points to inflation, says John Stepek. Here’s …
30 Jun 2020
Visit/investments/stockmarkets/601611/nasdaq-all-time-high-markets-and-the-real-economy
Stockmarkets

How can markets hit new record highs when the economy is in such a mess?

Despite the world being in the midst of a global pandemic, America's Nasdaq stock index just hit an all-time high. And it's not the only index on a bu…
3 Jul 2020