Interest coverage ratio
EBIT divided by interest expense — how many times operating profit covers the interest bill. Below 1, the business is not earning enough to pay its interest.
In plain language
A company with a lot of debt has a lot of interest to pay. Whether it is heading for a default on that interest can be seen, as the workbook puts it, simply by comparing its earnings with the interest.
A ratio of 5 means operating profit is five times the interest bill — plenty of room. A ratio below 1 means the business earns less than it owes in interest, and is either borrowing more or raising equity just to keep going.
How it works
Section 8.11.3 pairs the ratio with Debt/Equity as the two leverage ratios. D/E measures how much debt there is; interest coverage measures whether the company can carry it.
The numerator is EBIT — earnings before interest and tax — which section 8.4.2 calls "a useful metric to measure the ability of the firm to meet the annual interest or financial expenses", and names as a significant input for this ratio.
The workbook's real example. Bharti Airtel in FY 2019 reported EBIT of Rs 47,626 million against finance costs of Rs 1,10,134 million, so operating profit was "way too inadequate to even service the interest expense". Kingfisher Airlines is the warning case: EBIT much lower than interest for several years, borrowing to pay interest, until lenders refused to put in more.
The checklist test. The Chapter 13 sample checklist treats a business as low-leverage if D/E < 1 and interest coverage > 3, continuously over the last five years.
The formula
Interest coverage ratio = EBIT ÷ Interest expense
A worked example
From the workbook's figures (Rs million, FY 2019):
Interest coverage = 47,626 ÷ 1,10,134 = 0.43×
Earnings covered less than half the interest bill.
A downturn test — illustrative, Rs crore. An auto components maker:
| Normal year | Demand slump | Slump + costlier debt | |
|---|---|---|---|
| EBIT | 240 | 144 | 144 |
| Interest | 60 | 60 | 80 |
| Coverage | 4.0× | 2.4× | 1.8× |
In a normal year it passes the checklist's > 3 test comfortably. A 40% fall in EBIT takes it below 3. If its loans are then refinanced at higher rates and interest rises to Rs 80 crore, coverage falls to 1.8× — still above 1, but with little room left before earnings stop covering interest.
Why NISM asks about it
Chapter 8 (Company Analysis – Financial Analysis) defines the ratio among the leverage ratios in section 8.11.3 and uses Bharti Airtel and Kingfisher to illustrate it. Chapter 13 (Qualities of a Good Research Report) sets the > 3 benchmark in its quantitative checklist. Expect a computation from a P&L and a question on what a ratio below 1 signals.
Common exam traps
- EBIT, not EBITDA and not PAT. EBITDA flatters coverage by ignoring depreciation; PAT is already after interest, so it cannot be the numerator.
- It covers interest only, not principal. The workbook says so explicitly — "we are not talking about principal repayment yet". A company can cover interest and still be unable to repay a maturing loan.
- Below 1, or negative, is a distress signal, not a rounding issue: earnings are less than interest, or there are losses while interest is still due.
- The checklist wants the ratio above 3 for five continuous years, not in the latest year only.
- Interest coverage and D/E answer different questions. A company with modest D/E but collapsing EBIT can still fail the coverage test.
Where this is taught
Free preparation for NISM Series XVRelated terms
- Core working capitalInventory plus trade receivables minus trade payables — the money permanently trapped in the operating cycle, stripped of cash and borrowings, which have nothing to do with trading.
- DuPont analysisBreaking return on equity into net profit margin × asset turnover × equity multiplier, to see whether ROE comes from profitability, efficiency or borrowing.
- EBITDAProfit from running the business, measured before interest, tax, depreciation and amortisation — so before how the company is funded and how it accounts for its assets.
- Quick ratioCurrent assets excluding inventory, divided by current liabilities — a stricter liquidity test than the current ratio, because inventory cannot reliably be turned into cash in a hurry.
- Return on Capital EmployedOperating profit as a percentage of all the capital in the business, equity and debt together — the return the enterprise earns before any question of how it was funded or taxed.
- Management BuyoutA leveraged buyout in which the company's own management team borrows to buy a majority stake from existing shareholders and takes control of the business it already runs.
- Interim resolution professionalThe professional the adjudicating authority appoints when an insolvency application against a company is admitted under the IBC, who takes over management and forms the committee of creditors.
- Basis pointOne-hundredth of one percentage point — the standard unit analysts use to describe small, exact changes in margins, yields and interest rates without ambiguity.
- Checklist approachUsing a fixed, written list of qualitative, quantitative and valuation questions before every investment decision, so judgement stays disciplined rather than based on memory or mood.
- Total adjusted debtThe debt figure used as the numerator of the Debt/Equity ratio: every interest-bearing liability, short or long term, plus pension deficit gaps and convertible instruments.
- EBITEarnings before interest and taxes — the workbook's operating profit, struck one step below EBITDA after depreciation and amortisation, and the profit that has to cover the interest bill.
- Financial creditorUnder the Insolvency and Bankruptcy Code, a creditor who receives consideration against the time value of money — in other words, one who earns interest on the amount outstanding.