What is Coverage Ratio?
A 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 ratio indicates that the business is in a stronger position to repay its debt. Some of the popular ratios include debt coverage, interest coverage, asset coverage and cash coverage.
The coverage ratio helps in tracking the debt situations of a company to help investors make wise investment decisions. If the same has been declining over the years, the investors know of the deteriorating financial state of the company.
Table of contents
- The coverage ratio is a company’s capacity to pay off and cover its liabilities, obligations, debt, leasing payments, and dividends in a stipulated time.
- It implies how well a company’s earnings are sufficient to cover the liabilities and obligations. The higher the ratio, the higher earnings are available with the company to cover the liabilities and obligations.
- These are of various types, such as interest coverage, debt service coverage, asset coverage, and cash coverage.
- It can create a sense of financial responsiveness in the company and create frontiers for the business.
Coverage Ratio Explained
A coverage ratio depicts how capable a firm is of covering all its financial obligations without hampering the flow of the business. The stakeholders, external and internal, use these ratios to understand how strong a firm is financially and whether they can trust it with investments.
It can be used to conduct trend analysis Trend AnalysisTrend 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. for a company over a period. This calculation shows how its debt-repaying ability is moving over the periods. If it is going down, the firm can have a look at the issue and it can try to rectify 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.
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These ratios can further be derived in multiple terms, which categorize them into different types. Some of the types of coverage ratios are:
#1 – Interest Coverage Ratio
It determines 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 earned 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..
#2 – Debt Service Coverage Ratio
This ratio determines the company’s position to pay off its entire debt from its earnings. This ratio measures the company’s ability to repay the entire principal plus interest obligation of debt in the near term. If this ratio is more than 1, the company is in a comfortable position to repay the loan.
#3 – Asset Coverage Ratio
This ratio is similar to the Debt Service ratio, but instead of Operating IncomeOperating IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business., 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 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.
#4 – Cash Coverage Ratio
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. determines whether a firm can pay off its interest expense from available cash. It is similar to Interest Coverage, but instead of Income, this ratio will analyze how much cash is available to the firm. Ideally, this ratio should be greater than 1.
Based on the types of these ratios, the formula differs. In fact, analysts use the below-mentioned ratios to determine the firm’s position for its debt obligations in different ways:
Here, EBIT is the earnings before interest and tax.
Debt Service Coverage
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 the given 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 AssetsTangible assets are assets with significant value and are available in physical form. It means any asset that can be touched and felt could be labeled a tangible one with a long-term valuation. and its short-term liabilities are $100,000
- Cash Coverage
And non-cash expenses are $100,000
In this case, the ratio analysis depicts that the firm is in a comfortable position at the moment to pay off its debt using its earnings or asset.
Let’s take a practical example of an Indian company which is having quite a high amount of debt on its balance sheet. Bharti Airtel is a highly debt-ridden Indian telecom company because of the high CapEx requirements in this industry.
Below are some of the basic data for Bharti Airtel:
Source: Annual Reports and www.moneycontrol.com
The graph below clearly represents the trend of coverage ratios for Bharti Airtel:
As observed, these ratios are going down. It is because its debt has increased over the years, and EBIT has gone down. It happened because of the margin pressure and the entry of Reliance Jio into the market. If this continues in the future, Bharti Airtel could be in a bad position. As a result of this, it has to sell off its assets to repay the loan.
- At times, a firm takes more debt, but its effect comes to notice only over 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 is more than other companies. This is the case 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.
- Users should not use these ratios as stand-alone. While checking firm health, other ratios, such as liquidityLiquidityLiquidity is the ease of converting assets or securities into cash. or profitability ratios, also need to be analyzed alongside to make the decision.
Frequently Asked Questions (FAQs)
There are various coverage ratios. Firstly, the interest ratio is calculated by dividing EBIT by interest payment. Secondly, the debt service ratio is calculated by dividing operating income by total debt. Thirdly, the asset ratio is calculated by (tangible asset – short-term liabilities)/total debt, and cash coverage is calculated by (EBIT + noncash expense)/interest expense.
These establish the capacity of a company to pay off its liabilities and obligations, such as debt, interest, cash requirements, etc. A higher ratio means the company earns a good portion of its revenue and can efficiently pay off its liabilities and obligations.
Most organizations should aim for a cash flow ratio of at least 1.5x. This means that for every $1 in interest payments, there must be at least $1.50 in operating cash flows.
This article has been a guide to what is Coverage Ratio. We explain the formula & calculation examples for its types, including interest, debt service, asset & cash. You can learn more about from the following articles –