A coverage ratio is a measure of a company’s ability to service its debt and meet its financial obligations. The higher the coverage ratio, the easier it should be to make interest payments on its debt or pay dividends. The trend of coverage ratios over time is also studied by analysts and investors to ascertain the change in a company’s financial position.
Coverage ratios can be used to help identify companies in a potentially troubled financial situation – though low ratios are not necessarily an indication that a company is in financial difficulty. Many factors go into determining these ratios and a deeper dive into a company’s financial statements is often recommended to ascertain a business’ health. Net income, interest expense, debt outstanding and total assets are just a few examples of the financial statement items that should be examined. To ascertain whether the company is still a going concern, one should look at liquidity and solvency ratios, which assess a company’s ability to pay short-term debt, i.e. convert assets into cash.
While comparing the coverage ratios of companies in the same industry or sector can provide valuable insights into their relative financial positions, doing so across companies in different sectors is not as useful, since it might be like to comparing apples and oranges. Common coverage ratios include the interest coverage ratio, debt service coverage ratio and the asset coverage ratio.
Interest Coverage Ratio
The interest coverage ratio measures the ability of a company to pay the interest expense on its debt. The ratio, also known as the times interest earned ratio, is defined as a company’s earnings before interest and taxes (EBIT) divided by interest expense. An interest coverage ratio of two or higher is generally considered satisfactory.
Interest Coverage Ratio = EBIT / Interest Expense
Debt Service Coverage Ratio
The debt service coverage ratio measures how well a company is able to pay its entire debt service. Debt service includes all principal and interest payments due to be made in the near term. The ratio is defined as net operating income divided by total debt service. A ratio of one or above is indicative that a company generates sufficient earnings to completely cover its debt obligations.
Debt-service Coverage Ratio = Net Income / (Principal + Interest)
Asset Coverage Ratio
The asset coverage ratio is similar in nature to the debt service coverage ratio, but looks at balance sheet assets instead of comparing income to debt levels. The ratio is defined as a company’s total tangible assets — such as land, buildings, machinery and inventory — minus any short-term liabilities divided by its total debt outstanding. As a rule of thumb, utilities should have an asset coverage ratio of at least 1.5, and industrial companies should have an asset coverage ratio of at least 2.
Asset Ratio = (Total Tangible Assets – Current Liabilities) / Total Debt
This is the most basic of ratios used to assess the financial health of a company and its financial position with regard to its liabilities. From an investor’s perspective, it is important to identify the companies with a healthy coverage ratio to make the most out of one’s investment.
All companies have a mix of both debt and equity for its capital. A 100 percent debt model, though, would make it difficult to grow and expand as the company would always be hindered with interest payments. On the other hand, a 100 percent equity model also does not work for both private and public companies because the risk levels are too high for investors. For this reason, most companies follow a mix of both.
When a company is unable to repay its liabilities and is forced to sell its assets, then the possibility of bankruptcy increases. If a company files for bankruptcy, then investor returns are greatly diminished. Therefore, it is imperative for the investor to assess the risk aspect of the company as well as one’s investment, which the coverage ratio helps with.
It is an important ratio to calculate when preparing a financial model as it determines the amount of debt capital available for a business acquisition.
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