Covering Your Interest Ten Times Says Nothing About Repaying the Loan

EBIT is an accounting result, interest is a cash payment

The numerator can be large while the bank account is empty. Operating profit counts sales that have been invoiced and not yet collected, and it is reduced by depreciation that no one paid out this year — two adjustments pulling in opposite directions and neither of them cash. A company that has grown its receivables faster than its sales can cover its interest ten times on the income statement and still miss a payment date. Lenders know this, which is why the covenant is often written on EBITDA or on a cash-flow measure, and why a borrower should compute the same ratio on cash from operations before believing the comfortable version.

The pair to read it with

Interest cover and debt service coverage answer the two halves of the same question: can the business afford the cost of its debt, and can it afford to give the debt back. A high interest cover with a weak service coverage is the signature of a borrower who is comfortable this year and refinancing next; the reverse — thin interest cover with everything amortising slowly — is a borrower with no room for a rate rise. Neither ratio is a verdict on its own, and quoting the flattering one is a common enough habit that a lender will always ask for the other.

Frequently asked questions

What cover do lenders usually want?

It varies by sector rather than by rule, and the variation follows how stable the earnings are. A regulated utility with contracted revenue can be financed at a cover that would alarm a lender looking at a construction firm, because the utility's operating profit next year is broadly knowable and the builder's is not. What is worth doing in any sector is the stress test rather than the comparison: work out what fall in operating profit takes the cover to 1.0 — here, 90 % — and ask whether a year that bad has happened in the industry's recent past.

Should capitalised interest be included?

Yes, if the question is whether the money can be found. Interest capitalised into the cost of an asset under construction leaves the income statement but not the bank account, so a cover computed from the reported interest expense alone will look better than the year's actual outflow. The same applies to interest rolled up into the loan balance rather than paid: it is not this year's cash cost, and it is next year's larger principal. Take the figure from the cash flow statement or the loan schedule, not from the line the accounts happened to expense.