What is a coverage ratio?
A coverage ratio, roughly speaking, is a set of measures of a firm’s ability to repay debt and meet financial obligations such as paying interest or dividends. The higher the coverage ratio, the easier it should be to pay interest on your debt or pay dividends. The trend in coverage ratios over time is also studied by analysts and investors to check the development of a company’s financial situation.
Key points to remember
- Coverage ratios come in many forms and can be used to help identify companies in a potentially problematic financial situation.
- A coverage ratio, roughly speaking, is a measure of a company’s ability to repay its debt and meet its financial obligations. The higher the coverage ratio, the easier it should be to pay interest on your debt or pay dividends.
- Current coverage ratios include the interest coverage ratio, the debt service coverage ratio and the asset coverage ratio.
What does a coverage ratio tell you?
Coverage ratios come in many forms and can be used to help identify companies in a potentially troubled financial situation, although low ratios are not necessarily an indication that a company is in financial difficulty. Many factors come into play in determining these ratios and further analysis of a company’s financial statements is often recommended to check the health of a business.
Net income, interest expense, outstanding debt and total assets are just a few examples of the elements of the financial statements that need to be examined. To determine if the business is still in business, it is necessary to look at the liquidity and solvency ratios, which assess the ability of a business to pay its short-term debt (i.e. to convert its cash assets).
Investors can use coverage ratios in two ways. First, you can track the evolution of the company’s debt situation over time. In cases where the debt service coverage rate is barely within the acceptable range, it may be wise to look at recent company history. If the ratio gradually decreases, it may only be a matter of time before it falls below the recommended figure.
Coverage ratios are also valuable when looking at a company compared to its competitors. It is imperative to evaluate similar companies, because an acceptable interest coverage rate in one sector can be considered risky in another area. If the company you are evaluating seems out of step with the main competitors, this is often a red flag.
Although comparing the coverage ratios of companies in the same industry or sector can provide valuable information about their relative financial situation, it is not as useful to do it between companies in different sectors, because it could be like comparing apples and oranges. Current coverage ratios include the interest coverage ratio, the debt service coverage ratio and the asset coverage ratio. These coverage ratios are summarized below.
Types of coverage ratios
Interest coverage ratio
The interest coverage rate measures a company’s ability to pay interest expense on its debt. The ratio, also called the ratio multiplied by the interest earned, is defined as follows:
TheInterest coverage ratio=Interest chargesEBITTheor:EBIT=Earnings before interest and taxesTheThe
An interest coverage ratio of two or more is generally considered satisfactory.
Debt service coverage ratio
The Debt Service Coverage Ratio (DSCR) measures the extent to which a business is able to pay its entire debt service. Debt service includes all principal and interest payments to be made in the short term. The relationship is defined as:
TheDSCR=Total debt serviceNet operating profitTheTheThe
A ratio of one or more indicates that a business generates sufficient income to fully cover its debts.
Asset coverage ratio
The asset coverage ratio is similar in nature to the debt service coverage ratio, but it examines assets on the balance sheet rather than comparing revenues to debt levels. The relationship is defined as:
TheDSCR=Total debtTotal assets–Short-term liabilitiesTheor:Total assets=Tangible goods, such as land, buildings,machines and inventoryTheThe
In general, utilities should have an asset coverage ratio of at least 1.5, and industrial enterprises should have an asset coverage ratio of at least 2.
Other coverage ratios
Several other coverage ratios are also used by analysts, although they are not as important as the three above:
- the fixed cost coverage rate measures a firm’s ability to cover fixed costs, such as debt payments, interest expense, and equipment rental costs. It shows how well a company’s profits can cover its fixed expenses. Banks often take this ratio into account when assessing whether to lend money to a business.
- the loan life cover ratio (LLCR) is a financial ratio used to estimate the credit worthiness of a business or the ability of a borrowing company to repay an outstanding loan. The LLCR is calculated by dividing the net present value (NPV) of money available for debt repayment by the amount of outstanding debt.
- the EBITDA coverage ratio on interest is a ratio that is used to assess the financial sustainability of a business by examining whether it is at least profitable enough to pay off its interest expense.
- the preferred dividend coverage ratio is a coverage ratio that measures a company’s ability to repay its required preferred dividends. Preferred dividend payments are the expected dividend payments to be paid on the preferred shares of the company. Unlike common shares, dividend payments for preferred shares are set in advance and cannot be changed from quarter to quarter. The company is required to pay them.
- the liquidity coverage ratio (LCR) refers to the proportion of highly liquid assets held by financial institutions, in order to guarantee their continued ability to meet their short-term obligations. This ratio is essentially a generic stress test which aims to anticipate market-wide shocks and to ensure that financial institutions have appropriate capital preservation, to avoid any disruption of short-term liquidity, that could affect the market.
- the capital loss coverage ratio is the difference between the book value of an asset and the amount received from a sale compared to the value of non-performing assets being liquidated. The capital loss coverage ratio is an expression of the amount of transaction assistance provided by a regulator to involve an external investor.
Example of coverage rate
To see the potential difference between coverage rates, let’s look at a fictional company, Cedar Valley Brewing. The company generates quarterly earnings of $ 200,000 (EBIT is $ 300,000) and corresponding interest payments of $ 50,000. Given that Cedar Valley made a large portion of its borrowing during a period of low interest rates, its interest coverage rate seems extremely favorable:
TheInterest coverage ratio=$50,000$300,000The=6.0TheThe
However, the debt service coverage ratio reflects a large capital amount that the company pays each quarter for a total of $ 140,000. The resulting figure of 1.05 leaves little room for error if the company’s sales are hit unexpectedly:
Even if the company generates positive cash flow, it seems more risky from a debt perspective once debt service coverage is taken into account.