Interest coverage: the number under the profit

A friend told me a company he owns is perfectly safe on its debt. It made a profit last year, he said, so it can clearly pay its loans.

I hear that one a lot. Profit and the ability to actually pay your lender are two different questions, and the gap between them is where a lot of apparently healthy companies come undone.

There is one number that settles it, and it is never on the front page of a results release. Operating profit divided by the interest bill. Times interest earned. How many times over the business earns what it owes the bank.

Take two companies. Same operating profit this year, both firmly in the black. Company A owes 60 of interest on a 300 operating profit, so it covers its interest more than 5 times over. Company B owes 200 on the same 300, covering it just 1.5 times. On the P and L they both look fine.

Now serve up an ordinary bad year and knock 40 percent off operating profit for both. Company A still covers its interest 3 times over. Company B drops to 0.9. Its profit no longer covers the interest at all, and the year flips to a loss. It would take an 80 percent collapse to put A there. B only needed a 33 percent dip.

Same headline profit. One has a cushion. The other has a trapdoor.

Lenders watch this line too. Loan agreements often require coverage to stay above a set level, so a company can breach its covenant before it has missed a single payment.

Read the number under the profit before you trust the profit

The same two companies, line by line

Put rupees on it so you can redo it on paper. Both companies sell Rs 2,000 crore a year and earn an operating profit (EBIT, earnings before interest and tax) of Rs 300 crore. Company A borrowed Rs 600 crore at 10 percent, so its interest bill is Rs 60 crore. Company B borrowed Rs 2,000 crore at the same 10 percent, so it pays Rs 200 crore.

Walk down the P and L. Company A: Rs 300 crore of operating profit, less Rs 60 crore of interest, leaves Rs 240 crore before tax. Company B: Rs 300 crore less Rs 200 crore leaves Rs 100 crore. Both report a profit. Both can call it a good year. The coverage ratio is the only line that tells you how differently they are built.

Now the bad year. Operating profit falls 40 percent to Rs 180 crore for both. Interest does not fall, because the lender does not share your bad year. Company A: Rs 180 crore less Rs 60 crore is still Rs 120 crore of profit before tax. Company B: Rs 180 crore less Rs 200 crore is a loss of Rs 20 crore. Same sales, same margins, same shock. Only the debt is different.

How far can profit fall before the interest is not covered?

There is a one line formula for the trapdoor. The fall in operating profit that takes coverage to exactly 1 is one minus interest divided by operating profit. For Company A that is 1 minus 60 over 300, which is 80 percent. For Company B it is 1 minus 200 over 300, which is 33 percent. That is where the 80 and the 33 in the opening come from.

Read it the other way and it becomes a stress test. Ask how bad a normal bad year is for this kind of business. A cyclical business can lose a third of its operating profit in one downturn. A company with coverage of 1.5 has no room for that.

Two ways the cushion shrinks

A fall in profit is only half of it. The other half is the interest bill itself. Bank loans are often at floating rates, so when rates rise, the bill can rise with no change in the business.

Run it on Company B. Its Rs 2,000 crore of debt at 10 percent costs Rs 200 crore. If its borrowing rate goes up by 2 percentage points to 12 percent, the bill becomes Rs 240 crore and coverage drops from 1.5 to 1.25, before a single customer has left. Company A on the same rise goes from Rs 60 crore to Rs 72 crore of interest, and coverage moves from 5.0 to about 4.2. Same shock, very different meaning.

The free Learn module on leverage reads coverage with the same bands: below 1.5 is survival risk, 2 to 3 is thin, above 5 is comfortable. It also pairs coverage with net debt to EBITDA, because coverage tells you whether this year's profit carries the debt and the debt ratio tells you how big the debt is. You can read it at Leverage, debt and financial risk, with a quiz and a certificate at the end.

Where to find the two numbers

You do not need a data terminal. The quarterly results filing on NSE or BSE has both lines.

1. Find profit before taxIt is printed on the results statement every quarter.
2. Add back finance costsSchedule III puts interest on its own line, called finance costs.
3. Take out other incomeInterest earned on cash is not the business. Strip it to see core operating profit.
4. Divide by finance costsThat is coverage. Use the last four quarters added together, not one quarter.
5. Stress itKnock 30 to 40 percent off the profit and divide again.

Two cautions. Use four quarters, because one quarter of a seasonal business can make coverage look far better or worse than the year. And look at the trend over three years. A company whose coverage slid from 6 to 4 to 2.5 is telling you its debt is growing faster than its profit, long before any covenant is breached.

The same logic runs through a company's cost structure. Fixed costs make profit swing harder than sales, and interest is the most fixed cost of all. The post on operating leverage shows the sales side of the same trapdoor, and same P/E is not the same price shows why a headline ratio needs a second number beside it.