The coverage ratio is the ability of the company to be able to cover its obligations including debt, lease obligations and dividend in any period of time frame and some of the popular ratios include debt coverage ratios, interest coverage ratios and fixed charge coverage ratio.

## Formula to Calculate Coverage Ratio

Coverage Ratios formulas are used to analyze a company’s ability to meet obligations. Obligations are in the form of debt payments, debt interest payments, or lease payments. The formulas for these three most popular ratios are as follows:

**#1 – The Fixed Charge Coverage Ratio**

**Fixed Charge Coverage = (EBIT+ Lease payments)/ (Interest payments+ Lease payments)**

**#2 – Interest coverage ratio**

**Interest Coverage = EBIT/ Interest payments**

**#3 – Debt coverage ratio**

**Debt Coverage = Cash Flow From Operations/ Total Debt**

### Explanation

The coverage ratios formula is used to determine how much a company earns operating profit or cash from operations to cover its liabilities in the form of interests or lease payments. Interest expense is a liability for the company which the company needs to pay to its lenders, who lend the company money to expand the business. Most part of the interest expense is due to the long term debt of the company that why this ratio is also considered as the solvency ratio as it signifies whether the company is solvent enough to pay the debt.

If the company is not able to generate enough operating profit to pay off the interest, then the debt holders can ask the company to file for bankruptcy and sell their assets to pay the debt to the debt holders. Creditors look for a higher ratio, which signifies that the company is covering the interest payment with its operating income generated through the normal course of the business. The coverage ratios are not represented in the form of a percentage; it is represented in the form of an absolute number to find out by how many times the operating profit covering the interest cost.

### Calculation Examples of Coverage Ratio Formula

Let’s see some simple to advanced examples to understand it better.

#### Example #1

**Let us try to understand how to calculate these three ratios with the help of an arbitrary Company A. We need to make some assumptions in order to calculate these ratios.**

Let us assume that the EBIT (earnings before interest and taxes) for company A are $400 million. And the company has taken some assets which are part of their balance sheet in a lease and did not buy the asset outright. Let’s assume that the lease payments for those assets combined for a quarter are $45 million. And the company has taken debt to buy assets. Let’s assume that the interest payments for that debt combined for a quarter is $50 million, and cash flow from operations, which is also known as CFO for company A is $3000 million. And the company has taken debt to buy assets. Let’s assume that the total debt taken by a company is $700 million.

Use the following information for the calculation of the coverage ratios formula.

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**#1 – Fixed Charge Coverage Ratio Formula**

Fixed Charge Coverage Ratio = ($400 + $45) / ($50 + $45)

=4.68

So the fixed charge coverage ratio for the company will be 4.68. The higher the ratio better it is as it signifies that the company is able to cover the liabilities almost 5 times over with the help of its operating profits.

**#2 – Interest Coverage Ratio Formula**

Interest Coverage Ratio = $400 / $50

=8.0

So the interest coverage ratio for the company will be 8. The higher the ratio better it is as it signifies that the company is able to cover the liabilities almost 8 times over with the help of its operating profits.

**#3 – Debt Coverage Ratio Formula **

Debt coverage ratio = $3,000 / $700

=4.29

So the debt coverage ratio for the company will be 4.29. The higher the ratio better it is as it signifies that the company is able to cover the debts with the cash generated from operations.

#### Example #2

**The operating profit or EBIT for industries for a quarter is Rs 17341 crore. And the interest expense or finance cost for the period is Rs 4,119 crore. We can calculate the interest coverage ratio formula for reliance for the quarter using these two numbers.**

Use the following information for the calculation of the interest coverage ratio.

Therefore, the calculation of the interest coverage ratio is as follows,

- Interest Coverage Ratio = 17341 / 4110

** Interest Coverage Ratio will be –**

The interest coverage ratio= 4.21

It signifies that the company is able to generate operating profit, which is four times over the total interest liability for the period.

#### Example #3

**The operating profit or EBIT for industries for a quarter is Rs 5800 crore. And the net interest expense or finance cost for the period is Rs 1116 crore. We can calculate the interest coverage ratio for reliance for the quarter using these two numbers.**

Use the following information for the calculation of the interest coverage ratio.

Therefore, the calculation of the interest coverage ratio is as follows,

The interest coverage ratio= 5800/1116

**Interest Coverage Ratio will be –**

Interest Coverage Ratio = 5.20

It signifies that the company is able to generate operating profit, which is five times over the total interest liability for the period.

### Relevance and Uses

The coverage ratios formula is one of the most important formulas for the creditors in order to find out the credit health of a company. It shows how many times the operating profit of a company from its business operations is able to cover the total interest expense for the company in a given period of time. Creditors or investors of a company look for this ratio, whether the ratio is high enough for the company. The higher the ratio better it is from the perspective of the lenders or the investors.

A lower ratio will signify both liquidity issues for the firm, and also in some cases, it may also lead to solvency issues for a company. If the company does not earn enough operating income from the normal courses of the business, then it will not be able to repay the interest of the debt.

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