Definition
Interest coverage, often called times interest earned, is earnings before interest and taxes divided by interest expense. A higher figure means more operating profit is available to service debt. US GAAP does not define the ratio, so each credit agreement and each analyst chooses the earnings measure and whether capitalized interest counts.
Why it matters in an audit or review
A falling ratio is a going concern indicator and a covenant risk. It also tests the completeness of recorded interest, since understated interest expense overstates coverage. Interest cost that is capitalized into an asset under ASC 835-20 never reaches expense, so the team checks whether the covenant formula uses interest incurred or interest expensed.
Example
Illustrative: earnings before interest and taxes of $900,000 and interest expense of $150,000 give coverage of 6.0 times. If $50,000 of interest is capitalized into a building under construction, expense is $100,000 and a formula based on expense shows 9.0 times, while one based on interest incurred still shows 6.0.
Common mistakes
- Applying a covenant formula that differs from the agreement's defined terms.
- Using net income instead of earnings before interest and taxes.
Sources
- AICPA, AU-C Section 520, Analytical Procedures
- FASB ASC 835-20, Interest, Capitalization of Interest
- AICPA, AU-C Section 570, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern
Definitions paraphrase AICPA and FASB guidance; read the standard itself before relying on a requirement. Example figures are illustrative. This page is guidance, not professional advice. Report an error