Interest Coverage and Solvency
Learn to assess a company's ability to service its debt using interest coverage, debt-to-EBITDA, and solvency metrics.
Learning Objectives
- Calculate and interpret interest coverage ratio
- Understand debt-to-EBITDA for debt capacity
- Apply fixed charge coverage for complete analysis
- Assess bankruptcy risk indicators
Interest Coverage and Solvency#
While leverage ratios tell you how much debt a company has, coverage ratios tell you whether the company can actually service that debt. A company can have moderate leverage but struggle with payments, or high leverage with comfortable coverage.
Solvency refers to a company's ability to meet its long-term debt obligations. Coverage ratios measure whether operating profits are sufficient to cover fixed financial obligations.
Interest Coverage Ratio#
The interest coverage ratio measures how easily a company can pay interest on its debt from operating profits.
Interest Coverage = EBIT / Interest Expense
A ratio of 5.0 means the company earns 5 times its interest expense—comfortable coverage.
Interpreting Interest Coverage#
| Range | Interpretation |
|---|---|
| > 10x | Very strong—interest is a minor expense |
| 5 - 10x | Healthy—comfortable margin of safety |
| 3 - 5x | Adequate—some risk if earnings decline |
| 1.5 - 3x | Concerning—limited room for error |
| < 1.5x | Dangerous—may struggle to pay interest |
| < 1.0x | Crisis—not covering interest from operations |
Example Calculation#
| Item | Amount |
|---|---|
| EBIT (Operating Income) | $500M |
| Interest Expense | $50M |
| Interest Coverage | 10.0x |
This company earns 10 times its interest expense—very strong coverage.
Industry Benchmarks#
| Industry | Typical Coverage | Notes |
|---|---|---|
| Technology | 10 - 50x | Low debt, high profits |
| Consumer Staples | 8 - 15x | Stable earnings |
| Utilities | 3 - 6x | Regulated, predictable |
| Airlines | 1 - 5x | Cyclical, capital intensive |
| Retail | 4 - 10x | Varies by format |
Cyclical Caution
Interest coverage looks great at earnings peaks but can collapse in downturns. For cyclical companies, check coverage at both peak and trough earnings levels.
Debt-to-EBITDA Ratio#
Debt-to-EBITDA measures how many years of EBITDA would be needed to pay off all debt—a key metric for credit analysis.
Debt-to-EBITDA = Total Debt / EBITDA
A ratio of 3.0x means it would take 3 years of EBITDA to fully repay debt (ignoring interest, taxes, and capex).
Interpreting Debt-to-EBITDA#
| Range | Credit Implication |
|---|---|
| < 1.0x | Minimal debt—investment grade |
| 1 - 2x | Low debt—strong credit |
| 2 - 3x | Moderate—investment grade |
| 3 - 4x | Elevated—lower investment grade |
| 4 - 5x | High—speculative grade (junk) |
| > 5x | Very high—distressed or LBO levels |
Why Lenders Love Debt-to-EBITDA#
- Standard metric: Used universally in credit analysis
- Loan covenants: Often a key covenant in credit agreements
- Comparable: Works across industries better than D/E
- Cash proxy: EBITDA approximates cash flow available for debt service
Example: Covenant Analysis#
| Covenant | Limit | Actual | Headroom |
|---|---|---|---|
| Debt-to-EBITDA | ≤ 4.0x | 3.2x | 20% buffer |
| Interest Coverage | ≥ 3.0x | 5.5x | 83% buffer |
This company has comfortable covenant headroom, reducing risk of technical default.
Fixed Charge Coverage#
Fixed charge coverage is more comprehensive than interest coverage, including all mandatory payments.
Fixed Charge Coverage = (EBIT + Fixed Charges) / (Fixed Charges + Interest)
Fixed charges typically include lease payments and required principal payments.
What's Included in Fixed Charges#
| Charge Type | Include? |
|---|---|
| Interest expense | Yes |
| Operating lease payments | Yes |
| Preferred dividends | Yes (before tax adjustment) |
| Required debt amortization | Yes |
| Optional prepayments | No |
Interpreting Fixed Charge Coverage#
| Range | Interpretation |
|---|---|
| > 2.5x | Strong—comfortable coverage |
| 1.5 - 2.5x | Adequate—reasonable margin |
| 1.0 - 1.5x | Tight—limited flexibility |
| < 1.0x | Insufficient—cannot cover fixed charges |
Assessing Bankruptcy Risk#
Warning Signs#
| Indicator | Concern Level |
|---|---|
| Interest coverage < 1.5x | High |
| Debt-to-EBITDA > 5x | High |
| Negative free cash flow | Moderate to High |
| Declining revenue + high debt | Very High |
| Upcoming debt maturities + weak liquidity | Critical |
The Altman Z-Score#
The Z-Score combines multiple ratios to predict bankruptcy probability:
| Z-Score | Interpretation |
|---|---|
| > 2.99 | Safe zone—low bankruptcy risk |
| 1.81 - 2.99 | Grey zone—moderate risk |
| < 1.81 | Distress zone—high bankruptcy risk |
Multiple Signals
Don't rely on any single ratio. Combine interest coverage, debt-to-EBITDA, liquidity ratios, and cash flow analysis for complete bankruptcy risk assessment.
Practical Application#
Comprehensive Solvency Analysis#
| Metric | Company | Investment Grade Threshold |
|---|---|---|
| Interest Coverage | 6.5x | > 4x |
| Debt-to-EBITDA | 2.8x | < 3.5x |
| Fixed Charge Coverage | 2.2x | > 1.5x |
| Debt-to-Assets | 35% | < 50% |
Assessment: Company meets all investment-grade thresholds—solid solvency profile.
Trend Analysis#
| Year | Interest Coverage | Debt/EBITDA |
|---|---|---|
| 2020 | 8.0x | 2.0x |
| 2021 | 6.5x | 2.5x |
| 2022 | 5.0x | 3.2x |
| 2023 | 4.0x | 3.8x |
Concern: Coverage declining and leverage increasing—credit quality deteriorating.
Key Takeaways
- Interest Coverage = EBIT / Interest Expense—measures ability to pay interest
- Healthy coverage: above 5x; concerning: below 3x; crisis: below 1x
- Debt-to-EBITDA shows years of EBITDA needed to repay debt—key credit metric
- Investment grade: typically < 3.5x Debt/EBITDA; junk: > 4x
- Fixed Charge Coverage includes all mandatory payments, not just interest
- Check covenant headroom—tight covenants increase default risk
- For cyclical companies, test coverage at both peak and trough earnings
- Combine multiple solvency metrics for accurate bankruptcy risk assessment