Glossary

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.

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.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

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.

Advertisement
Advertisement - Article continues below

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

Most Popular

Visit/investments/property/house-prices/600840/the-biggest-risk-facing-the-uk-housing-market-right-now
House prices

The biggest risk facing the UK housing market right now

For house prices to stagnate or even fall would be healthy for the property market, says John Stepek. But there is a distinct danger that isn't going …
17 Feb 2020
Visit/economy/uk-economy/600824/how-the-bbc-can-survive-the-end-of-the-tv-licence
UK Economy

How the BBC can survive the end of the TV licence

The TV licence that funds the BBC is looking way past its sell-by date, says Matthew Lynn. Here's how it could survive without it
16 Feb 2020
Visit/economy/600838/money-minute-monday-17-february-good-news-ahead-for-the-uk-economy
Economy

Money Minute Monday 17 February: good news ahead for the UK economy?

Today's Money Minute looks to a week in which we get the latest employment and inflation numbers, plus retail figures for January and a slew of eurozo…
17 Feb 2020
Visit/investments/commodities/600729/the-rare-earth-metal-that-wont-be-a-secret-for-long
Sponsored

The rare earth metal that won't be a secret for long

SPONSORED CONTENT – You can’t keep a good thing hidden forever; now is the time to consider Pensana Rare Earths and the rare earth metals NdPr.
31 Jan 2020