Understanding Coverage Ratios
A coverage ratio is a metric that measures a company’s ability to service its debt and meet financial obligations like interest payments or dividends. Higher coverage ratios indicate a better ability to cover these obligations. Analysts and investors often study the trend in coverage ratios over time to understand changes in a company’s financial position.
Key Takeaways
- A coverage ratio measures a company’s ability to service its debt and meet financial obligations.
- Higher ratios indicate an easier capability to pay interest on debt or dividends.
- Coverage ratios come in many forms and help identify companies in possible financial trouble.
- Common coverage ratios include the interest coverage ratio, debt service coverage ratio, and asset coverage ratio.
Explore Different Coverage Ratios
Coverage ratios can take many forms, offering various insights into businesses. While these ratios can flag potentially troubled companies, low values aren’t an automatic sign of financial distress. Detailed scrutiny of a company’s financial statements is often necessary to assess its health.
Financial statement items such as net income, interest expense, debt outstanding, and total assets are essential. To verify ongoing financial health, consider looking at liquidity and solvency ratios, assessing a company’s ability to pay off short-term debts.
Investors can utilize coverage ratios by either tracking changes in a company’s debt situation over time or comparing the business against its competitors. Industry norms help determine whether ratios are acceptable, warning flags appear when a company is out of step with its key competitors. Comparing coverage ratios across different industries, however, might not be valid.
Important Types of Coverage Ratios
Interest Coverage Ratio
The interest coverage ratio measures the ability of a company to pay the interest expense on its debt. This ratio, also known as the times interest earned ratio, is defined as:
Interest Coverage Ratio = EBIT / Interest Expense
Where:
- EBIT = Earnings before interest and taxes
An interest coverage ratio of two or higher generally signifies satisfactory capability.
Debt Service Coverage Ratio (DSCR)
DSCR measures how well a company can pay its entire debt service, including all principal and interest payments due soon:
DSCR = Net Operating Income / Total Debt Service
A ratio of one or above indicates the company generates sufficient earnings to cover its debt obligations.
Asset Coverage Ratio
This ratio compares balance sheet assets to debt levels:
Asset Coverage Ratio = Total Assets - Short-term Liabilities / Total Debt
Where:
- Total Assets include items like land, buildings, machinery, and inventory.
Rough benchmarks suggest utilities should maintain an asset coverage ratio of at least 1.5 and industrial companies at least 2.
Other Coverage Ratios
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Fixed-Charge Coverage Ratio: Measures a firm’s ability to cover its fixed payments like debt, interest, and lease expenses.
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Loan Life Coverage Ratio (LLCR): Estimates a firm’s ability to repay an outstanding loan by examining the net present value (NPV) of the cash available for debt repayment.
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EBITDA-to-Interest Coverage Ratio: Assesses financial durability through an overview of earnings compared to interest expenses.
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Preferred Dividend Coverage Ratio: Measures the ability to cover preferred dividend payments that cannot be adjusted from quarter to quarter.
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Liquidity Coverage Ratio (LCR): Looks at the proportion of highly liquid assets a financial institution holds to ensure its ability to meet short-term obligations.
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Capital Loss Coverage Ratio: Expresses how much transaction assistance is given by a regulatory body for parties investing in nonperforming assets.
Inspirational Examples of Coverage Ratios
Fictional Company: Cedar Valley Brewing
Quarterly Profit: $200,000 (EBIT is $300,000)
Interest Payments: $50,000
Interest Coverage Ratio Calculation:
Interest Coverage Ratio = $300,000 / $50,000 = 6.0
Cedar Valley Brewing’s interest coverage ratio looks highly favorable at 6.0 due to borrowing during low-interest periods.
However, the debt-service coverage ratio portrays a different aspect:
Debt Service Payments: $190,000 (Including principal and interest)
DSCR Calculation:
DSCR = $200,000 / $190,000 = 1.05
Although positive cash flow exists, Cedar Valley appears riskier from a debt perspective with a DSCR of 1.05, indicating limited headroom for sales fluctuations.
Related Terms: interest coverage ratio, debt service coverage ratio, asset coverage ratio, liquidity ratios, solvency ratios.
