A coverage ratio can be defined as a measure of the company’s ability to pay back its debt and meet its financial obligations. In this regard, coverage ratio is used as a determinant to gauge the overall efficacy of the company in terms of their financial standing in line with the ability to meet their financial obligations.
Generally, higher coverage ratios are indicative of the relative ease with which the company can pay back its debts and obligations.
Therefore, coverage ratios can be best described as a metric that intends to measure the ability of the company to proceed with the smooth functioning of debts, in addition to the associated interest payments or dividends.
Coverage Ratios are mostly used by creditors and lenders in order to properly determine the financial standing of the borrower, and if the borrower will be able to meet its debts in a proper manner.
Types of Coverage Ratio
Coverage Ratio is a broader term that encapsulates several different types of ratios that are used by the creditors and the lenders in order to ensure that they are able to properly estimate the financial standing and the subsequent credit standing of the companies. Below are some of the most commonly used coverage ratios:
Subsequent Explanation of these coverage ratios is given below:
1) Interest Coverage Ratio
Interest Coverage Ratio refers to the ability of the company to be able to pay the interest expense on its debt. It only focuses on the component of interest, and therefore, it solely gauges the ability of the company to meet its interest-based expenses associated with debt.
Interest Coverage is also referred to as times interest earned. This captures the number of times the company can pay its interest expense on debt with its current level of operating income.
In this regard, it can be seen that there is a general benchmark, of an Interest Coverage Ratio of 1.5, which is indicative of the financial position of the company, which is considered to be a minimum acceptable ratio. Before an Interest Coverage Ratio of 1.5, the default risk of the underlying risk is considerably higher. Therefore, in this case, lenders might also refuse to lend money to the company.
Formula for Interest Coverage Ratio
Interest Coverage Ratio is calculated using the following formula:
Interest Coverage Ratio = Operating Income / Interest Expense
Example of Interest Coverage Ratio
The concept of Interest Coverage Ratio is further illustrated through the following example:
Mark and Co. reported an operating income of $100,000. The total interest payments that need to be paid by the company amount to $50,000.
In the scenario presented above, Interest Coverage Ratio is calculated using the following formula:
Interest Coverage Ratio = $100,000 / $50,000 = 2 times
This implies that Mark and Co. can pay the interest payable twice using their operating income.
2) Debt Service Coverage Ratio
The Debt Service Coverage Ratio is used in order to evaluate the company’s underlying ability to pay back the debt, as well as the interest using the income they have generated over the course of time.
The differential between Interest Coverage and Debt Service Ratio is the fact that where on one hand, Interest Coverage Ratio gauges the interest payment ability, Debt Service Coverage includes both, interest, as well as payment.
Debt Service Ratio is used by banks or financial institutions that are approached by companies in order to get the loan approved. The general rule states that an ideal Debt Service Coverage Ratio should be equal to more than 2 or higher.
In the cases where companies have a Debt Service Coverage Ratio of less than 1, it implies that the company does not have sufficient funds to cover interest and the principal payment.
Formula of Debt Service Coverage Ratio
Debt Service Coverage Ratio is calculated using the following formula:
Debt Service Coverage Ratio = Operating Income / Total Debt that needs to be serviced
Example of Debt Service Coverage Ratio
The concept of Debt Service Coverage Ratio is illustrated using the following example:
Mark Co. reported an Operating Income of $500,000. The total debt that they need to serve in the coming year amounts to $100,000. This amount includes both interests, as well as the principal.
In the scenario above, Debt Service Coverage Ratio is calculated using the following formula:
Debt Service Coverage Ratio = 500,000/100,000 = 5 times
It can be seen that Mark Co. can pay the principal and the interest amount for 5 times.
3) Cash Coverage Ratio
Cash Coverage Ratio is another coverage ratio that draws a comparison between the cash that the company has, compared to the annual interest expense that is borne. This solely compares the liquidity of the company to the interest expense that the company has to bear relative to its debt.
The main premise of calculating cash coverage ratio lies on the realm of assessing if the company has enough liquidity to cover its interest expenses.
Formula of Cash Coverage Ratio
Cash Coverage Ratio is calculated using the following formula:
Cash Coverage Ratio = Total Cash / Total Interest Expense
Example of Cash Coverage Ratio
The concept of cash coverage ratio is illustrated via the following example:
Mark Co. reported an annual income of $150,000. They had cash in hand worth $25000. During the year, they accrued an interest expense of $2500.
In the scenario above, it can be seen that Mark Co.’s Cash Coverage Ratio can be calculated using the following formula:
Cash Coverage Ratio = 25,000/2500 = 10 times
This implies that the company has enough cash to pay the interest for as many as 10 times.
3) Asset Coverage Ratio
Asset Coverage Ratio is a coverage ratio that is used to assess if the company has sufficient assets that, if needed, can be sold in order to repay the debt obligations. In other words, this ratio determines whether the company has sufficient assets that can be used to pay debt obligations.
As per the industry standards, it can be seen that the acceptable level of asset coverage is normally 1.
However, in the case where the Asset Coverage Ratio is greater than 1, it implies that the company would be able to pay off its debt without having to sell off any of its assets.
Formula for Asset Coverage Ratio
Asset Coverage Ratio is calculated using the following formula:
Asset Coverage Ratio = [(Total assets – Intangible assets) – (Current liabilities – Short-term debt)] / Total debt obligations
In the formula above, Net Assets are used because it considers the fact that all other liabilities are going to be settled first before paying off the debt obligations.
Example for Asset Coverage Ratio
The concept of Asset Coverage Ratio is illustrated via the following example:
Mark Co. has the following balances at the end of the year:
Total Assets: $100,000
Intangible Assets: $30,000
Current Liabilities: $30,000
Short-Term Debt: $20,000
Total Debt: $10,000
In the example above, it can be seen that the asset coverage ratio is calculated as follows:
Asset Coverage: [(100,000 – 30,000) – (30,000 – 20,000)] / 10,000
Asset Coverage = 6
This implies that the organization is going to be able to pay all of its debt-related obligations without selling off its assets. Therefore, the overall financial position of the company is considered good, and apparently, there should be no issue in paying back the amount. From the creditor’s or the lender’s perspective, this would be a relatively low-risk option.