What is the interest coverage ratio?

The interest coverage ratio measures a firm's ability to pay interest expenses from operating earnings by dividing operating income (or EBIT) by interest expense. For professional service firms with debt, this ratio indicates comfort level in meeting interest obligations. Higher ratios indicate more cushion; a ratio below 1.5 suggests a limited margin for earnings decline.

Key characteristics

• Operating income divided by interest expense

• Measures the ability to pay interest from operations

• A higher ratio indicates a greater safety margin

• Below 1.0 means operations cannot cover interest

• Common lender covenant

• Should be monitored for firms with debt

Why it matters for professional service firms

Interest coverage reveals whether operating earnings comfortably cover debt interest costs. A ratio of 5.0 means earnings could drop 80% and still cover interest. A ratio of 1.5 means that only a 33% decline in earnings would create problems. Professional service firms with debt should track interest coverage to ensure a comfortable cushion. Declining coverage warrants attention before it becomes a constraint.

Real-world example

Patricia's consulting firm had $85K annual interest expense. Operating income: $320K. Interest coverage: 3.8x (earnings could drop 74% and still cover interest). A new project required an additional $200K in debt at 7% ($14K in annual interest)—new interest expense: $99K. Coverage would drop to 3.2x if operating income were to hold. Acceptable, but analysis also considered: what if revenue dropped 15%? Operating income might fall to $245K, coverage 2.5x. Still acceptable but less comfortable. The analysis informed the decision to proceed while building a cash reserve to reduce debt dependency.