Using the Interest Coverage Ratio to Analyze Debt Expense

The interest coverage ratio measures the ability of a firm to meet its interest payments.

The larger the ratio, the more likely the firm can meet its payments. The lower the ratio, the greater the risk that the company may default on its loans.

The ratio divides operating income (income before interest and taxes, or EBIT) by interest expense.

Operating Income/Interest Expense

Analysts typically require minimum ratios of four to qualify for strong credit ratings.

The following table shows the financial ratios for the Software Industry, Microsoft, the S&P 500, Luxottica Group, Specialty Retail, and Sunny Sunglasses Shop.

Sunglasses Hut Int. (Luxottica Group)

"NA" indicates interest expense is zero or negligible. Microsoft did not incur any interest expense. Additionally, the software industry generally has very high profit margins and low debt, creating very high coverage ratios.

The retail industry, on the other hand, has lower profit margins than software, resulting in less operating income to cover interest expenses.

Sunny Sunglasses Shop has ten times the operating income to cover debt expenses, more than enough to receive a strong credit rating and higher than the industry average of 6.1. Luxottica Group, with a strong operating margin, has even more room to cover debt expenses.

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