An analytical tool that measures the ability of a firm to pay its interest obligations. It relates operating profit to interest expense:

Interest cover = operating profit/ interest expense

Operating profit refers to earnings before interest and tax (EBIT). The higher the interest cover the lower the possibility that a company will have insufficient profit to cover its interest expenses out of earnings before interest and tax. If a company’s interest cover is very low or approaching 1.0, this would be a bad omen, as it would be on the verge of failing to meet its obligations. Therefore, lenders closely monitor interest cover before agreeing to provide additional loans to a company. The following example shows interest cover for three companies:

For company C, interest cover is very healthy: profit could decrease by eight times before the company would fail to cover interest due on its loans. Company B is in serious trouble: any decline in profit would mean it is no longer able to pay interest. In the middle comes company A, it is not faring as good as company B, but is much better than company C. Profit of company A could drop by four times before it would be unable to pay interest due on its borrowings.