Debt and interest coverage

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Key idea: Interest coverage shows how many times profit covers the interest bill. Thin coverage means a bad year can become a crisis.

Debt is not bad in itself. A steady company borrowing at a low rate to fund good projects can raise returns for owners. The danger is when the debt payments outgrow the business's ability to pay them.

Interest coverage = operating profit (EBIT) / interest expense. Coverage of 10x means profit could fall by 90% and still pay the interest. Coverage under about 2x leaves little room: one weak year and the company may need to borrow more, sell assets or issue new shares.

Also check when the debt matures. A company with a large loan due next year must refinance at whatever rates are on offer then, which can be painful if rates have risen.

Another common measure is net debt divided by EBITDA. Under 2x is generally comfortable for an ordinary business; above 4x is heavy, unless profits are very steady, as with many utilities.

Quick check

Operating profit is $120 million and interest expense is $40 million. What is interest coverage?

Look up a company's debt on its stock page →

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