Interest coverage — usually expressed as a ratio — compares a company’s operating earnings to its interest expense, showing capacity to service debt from operations.

How it works

The standard formula divides EBIT (earnings before interest and taxes) by annual interest expense. A ratio of 3x means operating earnings cover interest three times over. Lenders set minimum interest coverage in credit agreements as maintenance or incurrence covenants. Venture-backed companies with minimal EBITDA may use adjusted metrics or interest-only periods before coverage tests bite. Declining coverage as debt grows or earnings fall precedes defaults and restructuring. Investors in growth-stage companies with venture debt monitor coverage alongside cash runway because early EBITDA may be negative — coverage becomes relevant as businesses mature toward profitability.

Why it matters

• Founders: Model interest coverage before adding debt layers. Rising rates increase interest expense and compress coverage without operational improvement.
• Investors: Weak coverage constrains portfolio company flexibility and increases bankruptcy risk in downturns.

Common mistake

Ignoring interest coverage while EBITDA is negative, then getting surprised when covenants activate upon reaching breakeven with thin margins.

Related ideas

Incurrence covenant, venture debt, leverage ratio, and EBITDA adjustments appear in credit underwriting alongside coverage.