What is the ‘Coverage Ratio’
The coverage ratio is a measure of a company’s ability to meet its financial obligations. In broad terms, the higher the coverage ratio, the better the ability of the enterprise to fulfill its obligations to its lenders. The trend of coverage ratios over time is also studied by analysts and investors to ascertain the change in a company’s financial position.
BREAKING DOWN ‘Coverage Ratio’
Common coverage ratios include the interest coverage ratio, debt service coverage ratio and the asset coverage ratio. While a comparison of coverage ratios of companies in the same industry or sector will provide valuable insights into their relative financial positions, comparing ratios across companies in different sectors will not prove as useful, since it may be tantamount to comparing apples and oranges.The use of coverage ratios can help identify companies in a potentially troubled financial situation but low ratios are not automatically indicative of danger. Many factors go into determining these ratios and a deeper dive into a company’s financial statements is often recommended to ascertain the 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.
Some of the more commonly used coverage ratios are analyzed below.
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.
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.
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 income in comparison to debt levels. The ratio is defined as a company’s total tangible assets minus any short-term liabilities divided by its total debt outstanding. Generally speaking, a ratio of two or above suggests that the company has sufficient assets on hand to manage its debt load, although an acceptable figure may vary depending upon the industry the company operates in.