Interest cover ratio: what lenders are testing

The interest cover ratio is a measure of how many times a business’s operating profit can pay the interest it owes on its borrowing. If the ratio is 4, operating profit is four times the interest bill, so there is a cushion if profit falls.

It matters to lenders because interest is a cost of borrowing that has to be paid on time. A business with plenty of cover has room for a poor month, whereas one with thin cover has little room for a late customer or a rise in costs.

The usual formula divides operating profit by interest expense: interest cover ratio = operating profit (EBIT) ÷ interest expense. EBIT is earnings before interest and tax, found in the profit and loss account.

The result is expressed as a multiple, such as 4 times, not a percentage. Some lenders and some textbooks use EBITDA in place of EBIT, which gives a higher figure because it adds back depreciation and amortisation. The British Business Bank describes EBITDA as a form of operating profit that stands for earnings before interest, taxes, depreciation and amortisation. Always check which version is being used.

To calculate interest cover you take operating profit from the profit and loss account and divide it by the interest charged in the same period. The numbers below are round and made up, to show the arithmetic.

Operating profit comes from your profit and loss account, and if you want the EBITDA version our guide to EBITDA shows how to build it.

A good interest cover ratio is one that leaves comfortable room above the lender’s own requirement, and each lender sets its own. This post does not quote a minimum because there is no single UK standard and lender tests change, so ask the lender what it looks at.

In general terms:

• A ratio near 1 means operating profit only just covers interest, so there is no cushion.
• A ratio below 1 means operating profit does not cover the interest bill, and the shortfall has to come from cash reserves or new borrowing.
• A higher ratio means more headroom, though very high figures can also mean the business borrows little.

Compare the figure with your own earlier years as well. A ratio that is falling while borrowing rises is worth acting on early.

Interest cover compares profit with interest only, whereas debt service cover compares cash available with all the repayments due, including the capital you pay back. The second is a tougher test for a business with a repayment loan.

Both ideas ask the same question in different ways: can the business pay what the finance costs? For the cash side, our guide to free cash flow shows how much cash is left after the business has spent on its assets.

Lenders use interest cover as one of several affordability checks and may also write a ratio into the loan agreement. The British Business Bank notes that a bank may include a debt to EBITDA ratio in a loan agreement, and that you would have to keep to the ratio set out in the agreement or risk having to repay the entire loan immediately.

A lender may also test affordability against a higher interest rate than the one you will pay, to see whether the business could cope if rates rose. Whether and how a lender does this is its own decision, so ask. Rates are influenced by the Bank of England’s base rate, which the British Business Bank notes influences the rate of interest on financial products and services.

Another made-up illustration, to show how a rise in interest cuts the cover even when profit does not move. Any lender’s actual tests may differ.

The commonest mistake is comparing figures that were built differently, so check the inputs before you trust the result. A ratio built on EBITDA looks stronger than one built on EBIT, and a ratio built on one strong year says little about the next.

• Using net profit, which is already after interest, instead of operating profit.
• Leaving out interest on leases, overdrafts or director loans that the business pays.
• Using last year’s interest when new borrowing has been taken on since.
• Ignoring seasonality, so a strong quarter hides a weak one.

If the sums matter for a decision, ask your accountant to rebuild them from the accounts. Capzy does not give accounting advice.

A low interest cover ratio can lead a lender to offer less, ask for security or decline, because the business has little headroom against a fall in profit. Each lender decides, and any offer is subject to status and lender criteria.

• A smaller amount or a longer term than you asked for.
• Security over business assets, or a personal guarantee from a director.
• A request for more information, such as recent management accounts.

Do not treat any of these as certain. They are possibilities, not promises. If a director is asked to guarantee a loan, read our guide to personal guarantees before signing, and consider independent advice.

You improve interest cover by raising operating profit, lowering interest or doing both. Because the ratio uses accounting profit, changes take time to show.

• Raise operating profit: review pricing, cut costs that do not earn their keep and chase slow payers.
• Lower the interest bill: repay expensive borrowing first, and compare the total cost of finance before you borrow again.
• Avoid unnecessary new borrowing until cover has recovered.
• Time large spending so that it does not coincide with a weak trading period.

When you do borrow, compare offers on total cost, not only the headline rate. Our guide on how to compare business lenders explains how.

Capzy is a credit broker, not a lender, and is paid by the lender. We do not calculate your ratios or give accounting or tax advice, so ask your accountant to check your figures. We introduce businesses to lenders whose products may suit them, and the lender makes the decision.

You can check your funding options with a soft search that does not affect your credit score. A full application to a lender may involve a hard search, and any offer is subject to status and lender criteria. The lender directory shows who offers which products.