Times Interest Covered Ratio

You run Furry Nation, America's finest purveyor of animal body suits. The company has $2 billion in debt, on which you pay 6% interest, or $120 million a year. You really wanted that platinum-encrusted fidget spinner and just couldn’t wait.

Furry Nation has revenues of $3 billion and, conveniently, has operating profits of $360 million. So how many times larger is your operating profit than your yearly interest?

Well, check out the $120 million of interest from before. That number gets divided into the operating profit number. The answer? Three. Why does this matter? Well, the 3x Times Interest Covered number is a solid indication of how easily you can pay the interest, if not the principal, of the debt you have borrowed.

Think about a normal boom and bust business cycle. In a bad year, your company might shrink to have only $2 billion of revenues and $180 million of operating profits, in which case, in that dismal year, it would have only a 1.5x times interest coverage. In a great year with, say, $900 million of operating profit, the coverage ratio would be 6x, or 600%, or 6 times. Put your butt in the seat of the lender. If you’re the one who loaned the $2 billion at 6 percent, you’re getting pretty nervous about being able to collect your debt when operating profits are down to just 1.5x. But at 6x, well, you sleep like a baby, happy to keep collecting your interest payment dough.

So why do we use operating profits instead of net income or after-tax profits when we calculate this times interest ratio? Because interest costs are tax-deductible. They are a cost, just like plastic, office building rent, or mandatory company yoga retreats. The cost of renting money is treated, for tax purposes, really no differently than the cost of renting a building.

So we don’t worry about taxes when we’re focused on only repaying our debts. Just don't try to use that excuse when tax time comes around. Uncle Sam don't play.