Accounting Ratio Analysis – Interest Cover
The interest cover ratio shows whether a company is earning enough profits before interest and tax to pay its interest costs comfortably, or whether its interest costs are high in relation to size of its profits, so that fall in Profit Before Interest and Tax (PBIT) would when have a significant effect on profits available for ordinary shareholders.
Interest cover = Profit before interest and tax / Interest charges
An interest cover of 2 times or less would be low, and should really exceed 3 times before the company’s interest costs are to be considered within acceptable limits.
Although preference share capital is included as prior charge capital for the gearing ratio, it is usual to exceed preference dividends from “interest” charges. We also look at all interest payments, even interest charges on short-term debt, and so interest cover and gearing do not quite look at the same thing.