What is Coverage Ratio?
Coverage Ratios are the financial ratios which are used to determine whether the firm can pay off its debt obligation. If this ratio is on the higher side, that means the firm is a healthier position to return its debt. Usually, It is used to compare a firm’s capability against similar companies or comparing the trend against previous years.
Top 4 Types of Coverage Ratio with Formula
Analysts use below-mentioned coverage ratios to determine the firm’s position for its debt obligations:
#1 – Interest Coverage Ratio
It is used to determine how well a company can pay off its interest in debt using its earnings. It is also known as Times Interest Earn Ratio.
Interest Coverage Ratio Formula
Interest Coverage Ratio Formula = EBIT / Internet Expense
#2 – Debt Service Coverage Ratio
This ratio determines the company’s position to pay off its entire debt from its earnings. 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.
Debt Service Coverage Ratio Formula
Debt Service Coverage Ratio Formula = Operating Income / Total Debt
#3 – Asset Coverage Ratio
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.
Asset Coverage Ratio Formula
Asset Coverage Ratio Formula = (Tangible Asset – Short Term Liabilities)/Total DebtOperating Income / Total Debt
#4 – Cash Coverage Ratio
Cash Coverage 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.
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Cash Coverage Ratio Formula
Cash Coverage Ratio Formula = (EBIT + Non Cash Expense)/Interest Expense
Examples of Coverage Ratios
Below we have taken the basic and practical examples of Coverage Ratios.
Coverage Ratio Example #1
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 expense for giving period =debt * interest rate
=700,000*6% = $42,000
- Debt Service Coverage
total debt payable (Principal plus interest)
- Asset Coverage
Let’s say the firm is having $900,000 of tangible assets 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.
Coverage Ratio Example #2
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 of 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.
Advantages of Coverage Ratios
- It can be used to do trend analysis for a company over the period. By calculating ratios over the period of times 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 into issue and try to correct that.
- These ratios can be used by lenders/ creditors 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.
Limitations of Coverage Ratios
- 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 which hides or distort these ratios.
- Some companies are having higher CapEx requirements, so their debt size will be more than other companies.
- That can be cases when companies change their accounting policies 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 liquidity or profitability ratios also need to be analyzed alongside to make the decision.
It is quite useful in checking the credit rating of a firm or to analyze at what rate, the loan should be given to the firm. But it needs to be used quite carefully keeping other factors in mind. Some companies require more debt compared to other companies so maybe their ratios are on the weaker side. There may be cases when a firm is trying to expand so it has taken a loan for capital expenditures which will give result after maybe 2 or 3 years. So, at present, its ratio may not be good. Just remember, ratios are helpful for analysis until these are analyzed keeping all factors in mind and not just by seeing the numbers as standalone.
This 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 –