5.3.4 Interest cover
Interest cover ratio measures the number of times the profit earned by a company covers its interest expense. It is calculated as follows:
Interest cover is usually expressed as a multiple, so, for example, an interest cover of two times means the company’s operating profits are twice the amount being paid as an interest expense (finance charge to lenders). Another way of putting it is to say that only half of its available operating profits are being used to pay its lenders. A company with an interest cover of one times is paying out all of its operating profits in interest. One with interest cover of less than one has to either borrow money to pay its current lenders or to draw down its existing cash resources. This is invariably a crisis situation, one normally where the company will be forced to pay very high interest rates. Such a situation greatly increases the likelihood of insolvency. A lender might be concerned if the interest cover is only one or less as it would indicate that there is little coverage for debt interest and that, if interest increases/profit declines, the lender may find their interest is not paid.
Below is the calculation of the interest cover ratio for Remote Sensors Plc.
| 2025 | 2024 | 2023 | |
|---|---|---|---|
| Net interest payable | 890 | 390 | 359 |
| Profit before interest and tax | 4,120 | 3,515 | 3,484 |
| Interest cover ratio | 4.63 | 9.01 | 9.70 |
You can observe that there is a significant decline in the interest cover ratio for Remote Sensors Plc from 9.01 times 2024 to 4.63 times 2025. This decrease occurred due to a significant rise in long-term interest-bearing loans and borrowings. However, the company is still in a good position to finance its interest expense from its operating profits.
The purpose of Activity 13 is to develop your skills to analyse and interpret various solvency ratios using the data of a real company.
Activity 13 Analysing long-term solvency
Look at Next Plc accounts [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] for the year ending 2022 and 2021 and answer the following questions.
- a.Calculate the following ratios to assess their financial leverage.
- i.Debt ratio
- ii.Leverage
- iii.Gearing
- iv.Interest cover.
Use the notes to the financial statements to retrieve more accurate or additional figures.
Use the following spreadsheet to carry out your analysis.
| Workings | 2022 | 2021 | |
|---|---|---|---|
| £m | £m | ||
| Current debt (bank loans and overdrafts) | |||
| Non-current debt (corporate bonds) | |||
| Total debt | |||
| Equity | |||
| Operating profit (PBIT) | |||
| Interest (note 5) | |||
| Total liabilities | |||
| Total assets | |||
| Debt ratio = (Total liabilities/Total assets) × 100 | |||
| Leverage = Debt/ Shareholders’ equity | |||
| Gearing = Debt/(Debt + Shareholders’ equity) | |||
| Interest cover = Operating profit (PBIT)/Interest |
Comment
| 2022 | 2021 | |
|---|---|---|
| £m | £m | |
| Current debt (bonds, bank loans and overdrafts) | 233.1 | 419.4 |
| Non-current debt (corporate bonds) | 815.7 | 837.0 |
| Total debt | 1,048.8 | 1,256.4 |
| Equity | 1,010.0 | 660.9 |
| Operating profit (PBIT) | 905.4 | 444.5 |
| Interest (note 5) | 36.1 | 42.9 |
| Total liabilities | 2,971.8 | 3,097.1 |
| Total assets | 3,981.8 | 3,758.0 |
| Debt ratio = (Total liabilities/Total assets) × 100 | 74.63% | 82.41% |
| Leverage = Debt/Shareholders’ equity | 103.84% | 190.10 |
| Gearing = Debt/(Debt + Shareholders’ equity) | 50.94% | 65.53% |
| Interest cover = Operating profit (PBIT)/Interest | 25.08 | 10.36 |
Workings
Debt ratio = (Total liabilities/Total assets) × 100
2022 = (2,971.8/3,981.8) × 100 = 74.63%
2021 = (3,097.1/3,758.0) × 100 = 82.41%
Leverage = Debt/Shareholders’ equity
2022 = (1,048.8/1,010.0) × 100 = 103.84%
2021 = (1,256.4/660.9) × 100 = 190.10%
Gearing = Debt/(Debt + Shareholders’ equity)
2022 = [1,048.8/(1,048.8 + 1,010.0)] × 100 = 50.94%
2021 = [1,256.4/(1,256.4 + 660.9)] × 100 = 65.53%
Interest cover = Operating profit (PBIT)/Interest
2022 = 905.4/36.1 = 25.08
2021 = 444.5/42.9 = 10.36
- b.How would you interpret the changes in these ratios? Use the box below to note your comments.
Feedback
Although the debt ratio has decreased from 82.41% in 2021 to 74.63% in 2022, the company is still highly geared. Similarly, the leverage ratio has also decreased from 190.10% to 103.84%; however, this decline is mainly attributable to a substantial increase in equity of the company, while the debt level has only slightly decreased. Gearing also shows a decline when compared to 2021. All of these ratios indicate that the company is highly leveraged, although the amount of leverage/gearing is decreasing as the company is now raising more capital through equity financing. An investor may perceive a high level of financial risk if investing in the company. However, the interest cover ratio of 25 shows that the company is able to cover its interest obligations very well and can comfortably service its debts. You may also observe that well-established and stable business organisations such as Next Plc tend to be highly leveraged as lenders trust lending money to them owing to their market reputation, financial stability, strong asset base, healthy and positive cash flows, and their ability to diversify risks across different segments.