Coverage Ratio: Definition, Formula and Calculations

Coverage Ratio

The coverage ratio is useless if your organisation has no debt service that requires interest payments. It can, however, be incredibly advantageous for those of you who are carrying debt with interest expense.
The coverage ratio is an accounting ratio used to assess a company’s capacity to cover its interest expense and whether there are adequate funds available to pay interest and earn a profit.

What is a Coverage Ratio?

A coverage ratio assesses a business’s capacity to pay its debts on time. Creditors and lenders frequently use coverage ratios, both for existing customers and for prospective customers seeking credit. Internally, the ratios can be employed, but usually only when loan covenants mandate that a business maintain a specified minimum ratio or face loan cancellation.

A coverage ratio might either focus on just the ability to pay back interest on a loan (the interest coverage ratio) or analyse the ability to pay back both interest and planned principal payments on a loan (the principal coverage ratio) (the debt service coverage ratio). The latter method of measurement is better since it provides the most complete study of a business’s ability to meet its debt obligations.

How does Coverage Ratio work?

Coverage ratios are available in a variety of forms and can be used to help identify organisations in potentially challenging financial situations, albeit low ratios are not always indicative of a company’s financial difficulties. Many elements go into creating these ratios, and a deeper dig into a company’s financial accounts is frequently required to determine the health of a business.

Net income, interest expense, debt outstanding, and total assets are just a few examples of financial statement components to investigate. Liquidity and solvency ratios, which analyse a company’s ability to pay a short-term debt, should be examined to determine whether the company is still a going concern (i.e., convert assets into cash).

Coverage ratios can be used by investors in one of two ways. For starters, they can monitor changes in the company’s debt position over time. In circumstances when the debt-service coverage ratio is just barely within acceptable limits, it may be worthwhile to examine the company’s recent history. If the ratio has been steadily falling, it may be just a matter of time before it goes below the recommended level.

Read Also: Unanticipated Inflation: Definition & Overview

Coverage ratios are also useful when comparing a company to its competitors. It is critical to compare similar businesses because a coverage ratio that is acceptable in one area may be considered dangerous in another. If the business you’re considering appears to be out of sync with significant competitors, this is usually a red indicator.

While comparing coverage ratios of companies in the same industry or sector might provide vital insights into their relative financial circumstances, doing so across companies in other industries or sectors is not as informative because it may be like comparing apples to oranges.

The interest coverage ratio, debt service coverage ratio, and asset coverage ratio are all examples of common coverage ratios. These coverage ratios are given in the table below.

Types of Coverage Ratio

#1. Interest Coverage Ratio

The interest coverage ratio (ICR), also known as the “times interest earned,” measures how many times a company’s operating income can cover its debt interest expenditures. An interest coverage ratio of 1.5 is considered the minimum acceptable ratio as a common benchmark. An ICR less than 1.5 may indicate a danger of default and an unwillingness by lenders to provide more money to the company.

Interest Coverage Ratio Formula

The interest coverage ratio is calculated as follows: operating income/interest expense

Example

A corporation declares a $1000,000 operational profit. The corporation is obligated to pay $120,000 in interest payments.

Interest coverage = $1000,000 / ($120,000) = 8.3x

As a result, the corporation could cover its interest payments 8.3 times over its operational income.

#2 Debt Service Coverage Ratio

The debt service coverage ratio (DSCR) assesses a company’s capacity to repay its debt commitments, including interest, using its operational income. When a corporation obtains a loan from a bank, financial institution, or another loan source, the DSCR is frequently calculated. A DSCR of less than one indicates that the corporation is unable to service its debt. A DSCR of 0.9, for example, indicates that net operating income is insufficient to repay 90 percent of yearly debt and interest payments. An optimum debt service coverage ratio is 2 or more as a general rule of thumb.

Debt Service Coverage Ratio Formula

Debt service coverage ratio equals operating income divided by total debt service.

Example

For example, the following figures appeared on a company’s financial statement:

Profits from operations: $1000,000

$200,000 in interest charges

$300,000 in principal payments

Debt service coverage = $1000,000/ (200,000 + $300,000) = 2.0x

As a result, the company’s operational revenue would be able to satisfy its debt service two times over.

#3. The Cash Coverage Ratio

This is another ratio, known as the cash coverage ratio, that compares the company’s cash balance to its yearly interest expense. This is a fairly conservative metric because it compares only cash on hand (no other assets) to the company’s interest expense relative to its debt.

Cash Coverage Ratio Formula

Cash coverage ratio = Total cash / Total interest expense

Example

Consider the following information about a company:

  • Cash on hand: $25 million
  • $6 million in short-term debt
  • Long-term debt totals $12.5 million.
  • $1.25 million in interest costs

Coverage in cash = $25 million / $1.25 million = 20.0x

This means that the corporation can recoup its interest costs twenty times over. Because the cash balance exceeds the overall debt level, the corporation can also use the cash on hand to repay all of the principal it owes.

#4. Asset Coverage Ratio

The asset coverage ratio (ACR) assesses a company’s ability to repay its debt commitments through the sale of assets. In other words, this ratio evaluates a company’s ability to fulfil debt commitments with assets once liabilities have been satisfied. The permissible level of asset coverage varies according to the industry. An ASR of 1 indicates that the corporation could only pay off all of its debts by selling all of its assets. An ASR greater than one indicates that the corporation could pay off all of its debts without selling all of its assets.

Asset Coverage Ratio Formula

Asset coverage ratio = ((Total assets – Intangible assets) – (Current liabilities – Short-term debt)) / Total debt commitments

Example

A company’s financials, for example, include:

  • $340 million in total assets
  • $60 million in intangible assets
  • Current liabilities amount to $60 million.
  • $40 million in short-term debt
  • Debt total: $200 million

Asset coverage = (($340 million – $60 million) – ($60 million – $40 million)) / $200 million = 1.3x

As a result, the corporation would be able to pay off all of its debts without having to liquidate all of its assets.

Other Coverage Ratios

Analysts employ several different coverage ratios, however, they are not as well-known as the three mentioned above:

  • The fixed-charge coverage ratio assesses a company’s capacity to cover fixed expenses such as debt payments, interest expense, and equipment lease expense. It demonstrates how well a company’s earnings can pay its fixed costs. When deciding whether to lend money to a business, banks frequently look at this ratio.
  • The loan life coverage ratio (LLCR) is a financial ratio used to estimate a firm’s solvency, or a borrowing company’s capacity to repay an outstanding debt. The LLCR is determined by dividing the amount of outstanding debt by the net present value (NPV) of the money available for debt repayment.
  • The EBITDA-to-interest coverage ratio is a ratio used to evaluate a company’s financial stability by determining whether it is profitable enough to cover its interest costs.
Read Also: Unanticipated Inflation: Definition & Overview
  • The preferred dividend coverage ratio is a coverage ratio that assesses a company’s capacity to make statutory preferred dividend payments. Preferred dividend payments are the necessary dividend payments made on the company’s preferred stock shares. Unlike common stock, preferred stock dividend payments are fixed and cannot be modified from quarter to quarter. They must be paid by the enterprise.
  • The liquidity coverage ratio (LCR) This ratio is essentially a generic stress test designed to predict market-wide shocks and ensure that financial institutions have adequate capital preservation to weather any short-term liquidity disruptions that may occur in the market.
  • The capital loss coverage ratio is the gap between the book value of an asset and the amount obtained from a sale in relation to the value of the nonperforming assets being liquidated. The capital loss coverage ratio expresses how much transaction help a regulatory body provides in order for an outside investor to participate.

Coverage Ratio Calculation and Interpretation

The numerator of the coverage ratio calculation is earnings/cash flow, and the denominator is the liability or fixed charge for which the ratio is being computed. A ratio greater than one usually implies that the earnings or cash flows are sufficient to pay down the liabilities for which the ratio is computed.

How to Evaluate a Multiple Coverage

There is no exact coverage multiple that is deemed excellent or undesirable. In general, the greater the ratio, the more likely a corporation will be able to pay its debts. A ratio less than 1:1 is a major indicator of imminent payment troubles. The simplest approach to assess a coverage ratio is to plot it on a long-term trend line; if the trend is dropping, this can be a warning of future problems, even if the ratio is currently high enough to show a reasonable level of liquidity. The ratio can also be compared to the same calculation for competitors to evaluate how the targeted business compares to its competitors.

Coverage ratios should be assessed with the volatility of a company’s cash flows. If cash flows fluctuate a lot over time, even a high coverage ratio may not be a good indicator of ability to pay. In contrast, if a company’s cash flows are exceedingly consistent and reliable, a considerably smaller coverage ratio may nonetheless offer a creditor or lender some assurance of payback.

Coverage Ratio FAQs

What is a good coverage ratio?

In general, an interest coverage ratio of at least two (2) is considered the minimum acceptable number for a corporation with constant, stable revenues. Analysts favour a coverage ratio of three (3) or higher.

Is a negative interest coverage good?

Although companies that are having difficulty servicing their debt may be able to stay in business, a low or negative interest coverage ratio is normally a huge warning flag for investors. In many circumstances, it signals that the company is in danger of going bankrupt in the near future.

What does the cash coverage ratio tell us?

The cash coverage ratio, which is expressed as a ratio of the cash available to the amount of interest to be paid, is useful for calculating the amount of cash available to pay for a borrower’s interest expense.

What is bad interest coverage ratio?

Any value less than one is considered a “poor” interest coverage ratio, as it indicates that your company’s earnings are insufficient to service its outstanding debt.

0 Shares:
Leave a Reply

Your email address will not be published.

You May Also Like