The interest coverage of a company can be calculated as:
Profits before interest and taxes Interest payable
A company with a greater interest coverage is able to pay off its interest payable easily compared to a company with a low interest coverage ratio. Hence, the greater the interest coverage ratio, the less risk a company has in terms of being able to pay off its interest.
How an options trader can use interest cover?
If an options trader is able to conduct a debt analysis and knows that the company’s interest cover ratio is too low to pay off its interest expenses, he may consider buying put options on the company as he predicts that the company may go into bankruptcy. Oftentimes, the market has not priced in the company’s ability to pay off its interest expenses. An options trader that can read into the company’s financials is able to act before the market does.