The interest coverage, also known as times interest earned (TIE), indicates the company’s ability to pay interest on its outstanding debt and to what extent operating income can decline before the company is unable to meet its annual interest expenses.
The lower the ratio, the higher the likelihood that the company will not be able to service its debt (pay interest expenses on its debt). If the interest coverage ratio gets below 1, the company is not generating enough earnings to service its debt.
Formula for Interest Coverage ratio
\[Interest\,Coverage\,ratio = \frac{{EBIT}}{{Interest\,expense}}\]
Example
Sun Pharma has Earnings before interest and taxes (EBIT) of Rs.13,520 and interest expenses in the amount of Rs.1,352. This gives an interest coverage ratio in the amount of 10, which means that the company has earned more than 10 times its interest expense. An interest coverage ratio of 10 provides sufficient coverage that the company will be able to service its debt.