We regularly monitor the health of the UK corporate sector, to inform views about risks to financial stability and the outlook for the economy.
One key measure of this is the share of companies with low interest coverage ratios (ICRs).
An ICR is the ratio between a company’s earnings before interest and tax and the interest payments made on their debt. It measures whether companies are generating sufficient earnings to cover their interest payments.
A company with a low ICR must divert more of its earnings to interest payments, and cannot use them to build resilience against future shocks by, for example, building cash balances. Such companies have a higher risk of failure. Having a large share of companies at a high risk of failure could represent a risk to financial stability.
We use a stylised experiment to explore the sensitivity of the ICRs of large UK companies, based on end-2019 debt levels given data availability. This approach is stylised for two reasons:
First, it does not account for any increases in debt over the Covid-19 (Covid) period, this may understate the current sensitivity of UK corporates to debt-servicing cost increases or earnings shocks. But, large UK companies had lower debt in aggregate by 2021 Q2 than pre-Covid, and so fewer large companies are likely to have experienced significant increases in debt similar to small and medium-sized enterprises.
Second, it does not account for measures that companies may take to protect themselves against interest rate rises, eg holding fixed-rate debt. This will overstate the sensitivity of ICRs.
The debt-weighted share of companies with ICRs below 2.5 – that is where their interest payments are equivalent to 40% or more of their income and therefore repayment difficulties are more likely – is currently at 37%, far below its historical peak (Chart A). An increase in borrowing costs of almost 400 basis points would be needed for this share to reach historical highs.
Chart A: Only a large increase in borrowing costs would markedly increase the share of businesses with a high debt-servicing burden
- Sources: Bank of England, Fame (Bureau van Dijk), S&P Capital IQ and Bank calculations.
- (a) The sample includes non-financial corporates only, excluding those engaged in oil, gas and mining. Sector results, and the maximum historical share, are drawn from the sample of all listed UK companies and largest private UK companies.
- (b) Copyright © 2021, S&P Global Market Intelligence (and its affiliates, as applicable).
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This debt-weighted share of companies with low ICRs varies by sector, as does its sensitivity to increases in borrowing costs (Chart B). The share with low ICRs would remain below historical peaks in all sectors but Arts and recreation and Wholesale trade, even in the face of large borrowing cost increases.
Chart B: Most sectors could withstand large increases in borrowing costs without exceeding their historical share of companies with a high debt-servicing burden
Similarly, only very severe earnings shocks would push the debt-weighted share with low ICRs in any sector to historical highs, and most sectors would remain comfortably below (Chart C).
Chart C: All sectors could withstand large earnings reductions without exceeding the historical share of companies with a high debt-servicing burden
This post was prepared with the help of Emily Clayton and Lindsey Rice-Jones.
This analysis was presented to the Financial Policy Committee in September 2021.
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