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Interest coverage ratio

The interest coverage ratio is the amount of operating income a company generates compared to the amount of its interest payments.

Expanded Definition

The interest coverage ratio is a measure of how solvent a company is.

Generally, the more debt a company carries, the more interest it has to pay to service that debt, be it interest on bonds or payments to banks on lines of credit. On the income statement, the interest expense is taken out after operating income (also called EBIT or "earnings before interest and taxes").

If the debt level is so high that EBIT barely covers the interest payments (so the coverage ratio would be 1.0 or 1.3, for instance), then the slightest shock could send the company into trouble.

However, if the company is earning enough from its business so that it has plenty of money left over after servicing its debt (e.g. a coverage ratio of 8.7 or 23.9), then the company isn't living too close to the edge and is better able to handle surprises. It's more solvent and can respond to changes more readily.

For a rule of thumb, we like to see interest coverage ratios in the high single digits or higher. Down below 5 or close to 1 or below (oh, the pain!), and you might want to look elsewhere for your investment dollars.

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