Issue #44

Interest Coverage Ratio And The 1.9x Warning

Happy Friday,

Welcome back to Balance Sheet. Every issue follows one real business with a problem hiding in its numbers, walks through what went wrong on the books, and shows you the fix.

Today's issue is about the interest coverage ratio, one division problem that shows whether a business can afford its own loans. Darnell Hughes runs a wholesale greenhouse in Lancaster County, Pennsylvania, and his interest coverage slid from 4.2x to 1.9x in two years while the business stayed profitable. His loan required at least 2.0x, and the bank's annual test was eight weeks away. The fix was a trailing-twelve-month coverage calculation, a simple stress test, and a conversation with the bank before the bank had to start it.

Let’s dig into how it started and what it can teach you before you sign or renew your next loan.

The letter he almost skimmed

Hillcrest Growers sells bedding plants, hanging baskets, and potted perennials to about forty garden centers across Pennsylvania, Maryland, and Delaware. In 2024, Darnell borrowed $1.8 million to add two acres of heated greenhouse space. The loan was interest-only for three years, variable rate, tied to prime, and it started at 6%.

The rate averaged 8.5% by 2026. A cold, wet spring cut retail demand, and natural gas for heating cost more than the year before. Hillcrest still made money. Darnell figured that meant the loan was fine.

In August, a routine letter from the bank reminded him of the covenants in his loan agreement. One line said Hillcrest had to maintain an interest coverage ratio of at least 2.0x, tested at fiscal year-end on October 31.

He had signed that agreement. He had never calculated the ratio. Yet he was able to fix it. Let’s learn how…

The formula

The interest coverage ratio (ICR), also called times interest earned, compares operating earnings to interest expense.

Interest coverage ratio = EBIT ÷ Interest expense

EBIT is earnings before interest and taxes, which matches operating income on most small business income statements. The result tells you how many times your earnings could pay the year's interest bill. Lenders call each one a "turn."

Some loan agreements use net interest expense, meaning interest expense minus any interest income the business earns on its cash. Hillcrest earned almost nothing on its operating account, so both figures were the same. Check which version your agreement specifies, because a large cash balance can make the net version look noticeably better.

Hillcrest at loan signing, and today:

Use trailing twelve months, meaning the last twelve months of actual results. Waiting for year-end means finding out after the test has already been failed.

Two hits that only broke it together

Darnell assumed the bad spring caused the problem. His accountant, Joanne Reiff, ran the numbers two other ways.

Old earnings, new rate: $450,000 ÷ $153,000 = 2.9x New earnings, old rate: $295,000 ÷ $108,000 = 2.7x

Either hit on its own would have passed the test comfortably. The ratio has earnings on top and interest underneath, so when earnings fall and rates rise in the same year, the damage compounds. That's what makes interest coverage such a good early warning. It caught a squeeze that neither the income statement nor the loan statement showed by itself.

Joanne also ran the stress test every borrower should know.

Minimum EBIT to pass = Required ratio × Interest expense Minimum EBIT = 2.0 × $153,000 = $306,000

Hillcrest was $11,000 short. One more cold month or one lost garden center account, and the gap would widen.

Three versions of the same ratio

Lenders don't all use the same numerator, so read your loan agreement for the exact definition.

EBITDA adds depreciation and amortization back (110,000 for Hillcrest), so it always produces the friendliest number. Subtracting CapEx (160,000) gives the most conservative view, because greenhouse roofs, heaters, and benches wear out and need replacing whether the bank counts them or not. EBIT sits in the middle, which is why it's the default when someone just says "interest coverage."

Darnell's agreement used EBIT. A 2.6x EBITDA figure would have felt reassuring and meant nothing for the test.

Reading the number

Here's a general guide for interpreting interest coverage.

Industry matters here. A regulated utility with steady revenue can live safely at a lower ratio. A seasonal or cyclical business, like a greenhouse, needs more cushion because earnings swing from year to year. Track the ratio quarterly so you see the direction early, while you still have options.

What Darnell did

He called his loan officer in September, six weeks before the test.

1. He brought Joanne's calculation, the stress test, and a written recovery plan.
2. The bank agreed to a one-time covenant waiver for the October test.
3. Hillcrest refinanced $1.2 million of the loan at a fixed 7.25%. The remaining $600,000 stayed variable.
4. He installed thermal curtains in the new greenhouses, cutting projected heating costs by $28,000 a year.
5. Joanne now updates the trailing-twelve-month ICR every month and sends it to Darnell with the financial statements.

The refinancing brought projected interest expense down to 87,000 on the fixed portion plus $51,000 on the variable portion. With the heating savings and a normal spring, Joanne projected EBIT of $360,000.

Projected interest coverage = $360,000 ÷ $138,000 = 2.6x

That's back above the covenant with real room to spare.

Back to Hillcrest

The letter that almost went in the recycling bin bought Darnell eight weeks. Banks are far more flexible with borrowers who show up early with the math and a plan. Borrowers they have to chase get fewer choices.

So run the ratio before your lender does. Pull EBIT and interest expense from your last twelve months, divide, and compare the result to the number in your loan agreement. If you don't know that number, find the agreement today.

Debt has a second side, though. The same borrowing that squeezed Hillcrest's coverage can also lift the return owners earn on their own money. On Friday, return on equity, and a dog boarding owner in Wisconsin who learned her business was earning less than an index fund.

Balance Sheet
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