What is the interest coverage ratio in a loan covenant?

How the ratio is built

Interest coverage = covenant EBITDA ÷ cash interest expense, both for the trailing twelve months.

The numerator is the same covenant EBITDA used in the leverage test, with the add-backs the agreement allows. Some older or bank-style agreements use EBIT instead, which subtracts depreciation and amortization and so produces a lower ratio for an equipment-heavy business. Read which one yours uses.

The denominator is defined with equal care. "Cash interest expense" in most agreements means interest actually paid or payable in cash on funded debt, including the interest portion of finance leases and the net cost of any interest rate hedge. It usually excludes:

• Paid-in-kind interest, which is added to the loan balance instead of being paid. See PIK interest.
• Amortization of fees and original issue discount, which are accounting charges, not cash leaving the business in the period.
• Interest income, unless the agreement tests net interest expense, in which case it is subtracted.
• One-time financing costs such as a breakage cost on a swap or a prepayment premium, which agreements commonly carve out.

Those exclusions matter most in a structure with a PIK-paying junior loan. A business can show comfortable cash interest coverage while its total debt is growing every quarter, which is why a lender that accepts PIK interest in the structure usually also tests total leverage.

Interest coverage against DSCR and FCCR

The three coverage ratios lenders use differ in what they subtract from earnings and what they count as the obligation. Interest coverage is the loosest of them, because it leaves out everything except interest.

A bank lending on an amortizing term loan cares whether principal gets paid, so it uses DSCR or FCCR; conventional bank lenders commonly look for debt service coverage of at least 1.25x. A private credit fund lending on a loan that repays mostly at maturity is making a different bet: that the business will stay healthy enough to refinance or be sold. For that lender, the question year by year is whether the interest is being earned, and interest coverage asks it directly. Comparing the two coverage tests in depth: DSCR vs FCCR.

Why it matters most on interest-only and floating-rate loans

On a fully amortizing loan, principal is often the larger part of the payment, and DSCR is the test that binds. As amortization gets lighter, principal shrinks as a share of what the business pays, and in an interest-only period it disappears. At that point DSCR and interest coverage measure the same obligation, and interest is the whole story; the two ratios differ only in what each agreement subtracts from earnings.

Most private credit and unitranche loans float: the rate is a base rate plus a fixed spread, reset every month or quarter. See SOFR plus spread. When the base rate rises, the interest bill rises with it and nothing in the business has changed. Interest coverage falls in step, and a covenant set when rates were lower can be breached on rates alone.

A worked example makes the mechanism plain. A services company borrows 10,000 on a floating-rate unitranche loan with light amortization. Covenant EBITDA is 2,700.

If the covenant minimum were 2.0 times, the business would pass at closing with a wide margin, still pass after the rate rise, and fail in the soft year, unless half the loan had been hedged, in which case it would pass narrowly. Nothing about the company's operations differs between the last two rows. That is why lenders on floating-rate deals often require the borrower to hedge part of the loan for the first years; see interest rate hedging requirements and swap vs cap.

Where you will see it, and how it is set

Interest coverage appears most often in private credit and unitranche agreements, usually as one of two financial covenants alongside a maximum total leverage ratio. The pair covers both risks: leverage says how much is owed, interest coverage says whether the cost is being earned. Some agreements test a single fixed charge ratio instead; lenders rarely impose all three.

The minimum is set from the lender's underwriting model with a cushion below the base case, often wider in the early quarters and tightening as the model expects leverage to fall. It is tested quarterly on a trailing twelve-month basis. In the first quarters after closing, trailing interest includes periods before the new loan existed, so agreements commonly annualize interest from the closing date instead: the first quarter's interest times four, then the first two quarters' times two, and so on. Check that clause: an annualized quarter with a one-time interest charge in it can distort the result.

Managing interest coverage

• Model the rate path, not today's rate. Run the covenant at the base rate you are paying now and at meaningfully higher levels. If a plausible rise breaches it, hedge part of the loan or negotiate a looser level.
• Know what the hedge counts as. Payments under a swap usually flow into cash interest expense. A rate cap costs an upfront premium, which agreements often exclude from the ratio. See interest rate swap.
• Watch the rate floor. A floor sets a minimum base rate, so falling rates may not help coverage as much as expected.
• Check revolver usage. A line drawn heavily at year-end adds interest the model may not have assumed.
• Keep the headroom visible. Compute the ratio monthly on the agreement's definitions and track covenant headroom, the fall in EBITDA the business can absorb before a breach.

If a breach is coming because rates rose rather than because the business weakened, say so early and show it. Lenders distinguish between the two, and an equity cure, an amendment or a partial paydown is easier to arrange when the business itself is performing. See what to do when you breach a loan covenant.