Interest Coverage Ratio

The Interest Coverage Ratio answers a simple but critical question: can the business earn enough profit to pay the interest on its long-term loans? Lenders care deeply about this ratio because it tells them how safe their interest payments are.

This ratio is also called "Debt Service Ratio" in some contexts, though the NCERT text uses only "Interest Coverage Ratio." It focuses purely on the servicing of interest — not the repayment of the principal amount of the loan.

Formula

Interest Coverage Ratio = (Net Profit before Interest and Tax) / (Interest on Long-term Debts)

What the numerator means

Net Profit before Interest and Tax (NPBIT) is the profit earned from operations before any interest expense is deducted and before income tax is paid. Why do we add back interest and tax? Because interest is the very item we are measuring coverage for — it must be included in the profit pool. Tax is added back because interest is deducted before tax; the profit available to pay interest is the profit before that deduction.

What the denominator means

Only interest on long-term debts is used. Interest on short-term borrowings (like bank overdraft or trade payables) is not included. This keeps the ratio focused on the solvency of the firm's long-term financing.

Significance

The ratio tells us the number of times the profit covers the interest obligation. A higher ratio means greater safety. If the ratio is 1.67 times (as in the illustration), the profit is 1.67 times the interest — so even if profit drops by about 40%, the firm can still pay its interest. A ratio of less than 1 means the firm does not earn enough profit to cover its interest; it would have to dip into reserves or borrow further just to pay interest, which is a serious red flag.

The textbook's worked examples for this topic now live in this chapter's Illustrations & practice tab, alongside their full solutions.

Accounting treatment note …