Five readings of interest cover for one borrower and one year, the rate and the EBITDA fall that break the covenant, and what a good ratio actually means.
The interest coverage ratio is earnings divided by interest, and which earnings and which interest decide the answer. On one illustrative borrower with 170.0 of floating-rate debt at 8.00 per cent, the same year reads 2.06x on EBIT, 2.94x on EBITDA and 3.65x on the covenant definition. Against a 3.00x covenant, the borrower passes with a 17.8 per cent EBITDA cushion that shrinks to 5.5 per cent without its add-backs.
Worked in full in Credit Analysis by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A mid-sized industrial company with a sponsor-backed term loan. All figures are illustrative, in millions, for the last twelve months.
| Input | Value |
|---|---|
| EBITDA, statutory | 40.0 |
| Add-backs claimed in covenant EBITDA | 6.0 |
| Depreciation and amortisation | 12.0 |
| EBIT | 28.0 |
| Maintenance capital expenditure | 8.0 |
| Term loan, floating | 170.0 |
| Base rate + margin = all-in rate | 4.25% + 3.75% = 8.00% |
| Arrangement fees amortised through interest expense | 0.9 |
| Interest income on cash | 1.0 |
| Interest cover covenant (minimum) | 3.00x |
Cash interest is 170.0 × 8.00% = 13.60. The income statement shows 14.50, because it includes 0.9 of arrangement fees being amortised, which is not a cash payment. A covenant that tests net cash interest also deducts the 1.0 of interest earned on cash, giving 12.60. That is three interest figures for one loan before any earnings figure has been chosen.
Interest coverage = Earnings measure / Interest measure
Excel, with EBITDA in B2 and debt and rate in B3 and B4: =B2/(B3*B4)
| Definition | Numerator | Denominator | Cover |
|---|---|---|---|
| EBIT / cash interest | 28.00 | 13.60 | 2.06x |
| (EBITDA − capex) / cash interest | 32.00 | 13.60 | 2.35x |
| EBITDA / P&L interest | 40.00 | 14.50 | 2.76x |
| EBITDA / cash interest | 40.00 | 13.60 | 2.94x |
| Covenant EBITDA / net cash interest | 46.00 | 12.60 | 3.65x |
The spread from the lowest to the highest reading is 1.59 turns of cover. None of the five is wrong; they answer different questions. EBIT cover asks whether the business earns its interest after paying for the wear on its assets. EBITDA less capital expenditure asks whether the cash the business generates pays it. The covenant figure asks only whether the agreement is breached, and it is the most generous because it adds back 6.0 of earnings management expects and nets interest income against the cost.
A credit analyst should state which one is being quoted. "Interest cover of 3.65x" and "interest cover of 2.06x" describe the same borrower in the same year.
The covenant is a minimum of 3.00x on covenant EBITDA over net cash interest. There are two ways to reach it.
Rates rise. Net interest can reach 46.0 / 3.00 = 15.33 before a breach. Add back the 1.0 of interest income and divide by the 170.0 of debt: the all-in rate can rise to 9.61 per cent, so the base rate can move up 161 basis points. On an unhedged floating loan, that is a single rate cycle.
EBITDA falls. At today's interest, covenant EBITDA can fall to 3.00 × 12.60 = 37.80, a fall of 17.8 per cent. But 37.80 is only 5.5 per cent below the statutory 40.0. If the add-backs do not materialise, the cushion is a third of what the certificate implies.
| Base rate move | All-in rate | Cash interest | EBIT cover | EBITDA cover | Covenant cover |
|---|---|---|---|---|---|
| −100 bp | 7.00% | 11.90 | 2.35x | 3.36x | 4.22x |
| None | 8.00% | 13.60 | 2.06x | 2.94x | 3.65x |
| +100 bp | 9.00% | 15.30 | 1.83x | 2.61x | 3.22x |
| +200 bp | 10.00% | 17.00 | 1.65x | 2.35x | 2.88x |
| +300 bp | 11.00% | 18.70 | 1.50x | 2.14x | 2.60x |
| +400 bp | 12.00% | 20.40 | 1.37x | 1.96x | 2.37x |
At +200 basis points the covenant breaks, with no change in trading. EBIT cover is then 1.65x. Some analysts use illustrative comfort levels of around 1.5x on EBIT and 3.0x on EBITDA; this borrower is at the first level after 300 basis points and is already below the second today. Leverage is 4.25x on statutory EBITDA, and the two measures are linked: at a given rate, cover is roughly the inverse of leverage times the rate, 1 / (4.25 × 8.00%) = 2.94x.
There is no single threshold, because the ratio depends on the definition and the rate. Two checks travel better than a target number. First, compute it on EBITDA less maintenance capital expenditure over cash interest, which is the closest the ratio gets to cash: 2.35x here. Second, solve for the rate and the EBITDA fall that take it to the covenant, 9.61 per cent and 17.8 per cent here, and compare them with a plausible downside. A ratio of 3.65x that breaks on a 161 basis point move is weaker than it reads.
Choose the earnings measure, choose the interest measure, and say which you used: 2.06x, 2.94x and 3.65x are all this borrower. Then solve for what breaks it. The book's own covenant test, cover on cash available for debt service against a 1.20x minimum, is worked in the free workbook for this case, and the version with scheduled repayment in the denominator is in how to calculate a fixed charge coverage ratio. The leverage side of the same borrower is in how to calculate net debt to EBITDA.
Interest coverage is earnings divided by interest expense for the same period. The usual analytical versions are EBIT over cash interest and EBITDA over cash interest. In this example EBIT of 28.0 over cash interest of 13.60 gives 2.06x, and EBITDA of 40.0 over the same interest gives 2.94x. A credit agreement defines its own version, usually on adjusted EBITDA and net cash interest.
It depends on the definition and on how floating the debt is. Here EBIT cover is 2.06x today but 1.65x after a 200 basis point rise in the base rate, and the covenant ratio of 3.65x falls to 2.88x, below a 3.00x minimum. Judge the ratio by the rate rise and the EBITDA fall it can absorb, not by the level alone.
Credit agreements often test net cash interest, deducting interest earned on cash. That flatters the ratio while cash is high and reverses when the cash is spent. In this case netting 1.0 of interest income moves the denominator from 13.60 to 12.60. An analyst should show cover gross of interest income as well.
This article is one calculation from Credit Analysis. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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