What is Coverage Ratio?
The coverage ratio indicates the company’s ability to meet all of its obligations, including debt, leasing payments, and dividends, over any specified time period. A higher coverage ratio indicates that the business is in a stronger position to repay its debt. Some of the popular coverage ratios include debt coverage, interest coverage, asset coverage and cash coverage.
Coverage Ratio Formulas
Let us discuss each of the coverage ratios along with its formula. Analysts use the below-mentioned ratios to determine the firm’s position for its debt obligations:
#1 – Interest Coverage
It is used to determine how well a company can pay off its interest in debt using its earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.. It is also known as Times Interest Earn RatioTimes Interest Earn RatioTimes interest earned is the ratio between earnings before interest and taxes and the interest expenses of the company over that specific period; it helps in determining the liquidity position of the company by determining whether it is in a comfortable position to pay interest on its outstanding debt..
Coverage Ratio Formula
#2 – Debt Service Coverage
This ratio determines the company’s position to pay off its entire debt from its earnings. The company’s ability to repay the entire principal plus interest obligation of debt in the near term is measured by this ratio; if this ratio is more than 1, than the company is in a comfortable position to repay the loan.
Coverage Ratio Formula
#3 – Asset Coverage
This ratio is similar to the Debt Service ratio, but instead of Operating Income, it will see whether debt can be paid off from its assets. If the firm is not able to generate enough income to repay debt, then whether the assets of the company such as land, machinery, inventory, etc. can be sold off to give back the loan amount. Usually, this ratio should be more than 2.
Coverage Ratio Formula
#4 – Cash Coverage
Cash CoverageCash CoverageCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets. is used to determine whether a firm can pay off its interest expense from available cash. It is similar to the Interest Coverage, but instead of Income, this ratio will analyze how much cash available to the firm. Ideally, this ratio should be greater than 1.
Coverage Ratio Formula
Let’s say a firm’s total “Operating Income” (EBIT) for the given period is $1,000,000, and its total outstanding principal debt is $700,000. The firm is paying 6% interest on the debt.
So, its total interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense. for giving period =debt * interest rate
=700,000*6% = $42,000
- Interest Coverage
- Debt Service Coverage
total debt payable (Principal plus interest)
- Asset Coverage
Let’s say the firm is having $900,000 of tangible assetsTangible AssetsAny physical assets owned by a firm that can be quantified with reasonable ease and are used to carry out its business activities are defined as tangible assets. For example, a company's land, as well as any structures erected on it, furniture, machinery, and equipment. and its short-term liabilities are $100,000
- Cash Coverage
And non-cash expenses are $100,000
By analyzing these ratios, it can be said that for now, the firm is in a comfortable position to pay off its debt using its earning or asset.
Let’s take a practical example of an Indian company which is having quite a high amount of debt in its balance sheet. Bharti Airtel is an Indian telecom company which is known as a very high debt-ridden company because of high CapEx requirement in this industry
Below are some of the basic data for Bharti Airtel:
Data in Rs Mil.
Source: Annual Reports and www.moneycontrol.com
In the below graph, we can analyze the trend of coverage ratios for Bharti Airtel:
As we can see that over the years, these ratios are going down. It is because its debt has increased over the years, and EBIT has gone down because of margin pressure and entry of “Reliance Jio” into the market. If this continues in the future, then Bharti Airtel could be in a bad position regarding its debt, or maybe it has to sell off its assets to repay the loan.
Use of Coverage Ratios
- It can be used to do trend analysis for a companyTrend Analysis For A CompanyTrend analysis is an analysis of the company's trend by comparing its financial statements to analyze the market trend or analysis of the future based on past performance results, and it is an attempt to make the best decisions based on the results of the analysis done. over the period. By calculating ratios over the period of time, it can be analyzed that how its debt repaying ability is moving over the periods. If it is going down, then the firm will have to look down on the issue and try to correct that.
- These ratios can be used by lenders/ creditorsCreditorsA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. before giving a loan. Whether the firm is worthy of loans and at what interest rate loan should be provided.
- Analysts use these ratios to determine the credit rating of the firm. If the ratings are good, then firms get a loan at lower interest rates.
- There may be the case that for a given period, a firm has taken more debt, but its effect will come into the next periods. Also, seasonality can be a factor that hides or distort these ratios.
- Some companies have higher CapEx requirements, so their debt size will be more than other companies.
- That can be cases when companies change their accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level., and because of that, these ratios can be affected.
- We should not use these ratios as stand-alone. While checking firm health, other ratios, such as liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. or profitability ratios, also need to be analyzed alongside to make the decision.
This article has been a guide to what is Coverage Ratio? Here we discuss the top 4 types of Coverage Ratio including interest coverage, debt service coverage, cash coverage, and asset coverage, along with practical examples. You can learn more about from the following articles –