Which of the following statements correctly defines the interest coverage ratio and its importance for lenders and investors?

• A. EBITDA divided by interest expense; assesses ability to meet interest payments.
• B. EBIT divided by interest expense; assesses ability to meet interest payments.
• C. Revenue divided by interest expense; assesses liquidity.
• D. Net income divided by interest expense; assesses profitability.

Answer: (B)

The interest coverage ratio shows how easily a company can meet its interest payments from operating earnings. It is calculated by dividing EBIT (earnings before interest and taxes) by interest expense, because EBIT reflects the operating profitability available to service debt after factoring in ongoing operating costs but before financing decisions and taxes. This makes the measure a direct gauge of the cushion available to cover interest costs from normal operations. Using EBITDA would overstate this ability since it excludes depreciation and amortization, which are real costs reflected in earnings. Using revenue would miss the cost side entirely, and using net income would mix in taxes and non-operating items, obscuring the true capacity to cover interest from core business activity. A higher ratio indicates stronger debt-service capacity, which is why lenders and investors rely on EBIT divided by interest expense.