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, the coverage ratio is used as a determinant to gauge the overall efficacy of the company in terms of its financial standing in line with its ability to meet its financial obligations.
Generally, higher coverage ratios indicate 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.
Creditors and lenders mostly use Coverage Ratios to determine the borrower’s financial standing properly, and if the borrower can meet its debts properly.
Types of Coverage Ratio
Coverage Ratio is a broader term that encapsulates several different ratios that creditors and lenders use to ensure that they can properly estimate the financial standing and the subsequent credit standing of the companies.
Below are some of the most commonly used coverage ratios:
A subsequent Explanation of these coverage ratios is given below:
1) Interest Coverage Ratio
The interest Coverage Ratio refers to the company’s ability 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 the time’s 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, lenders might refuse to lend money to the company in this case.
The formula for Interest Coverage Ratio
The 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 to evaluate the company’s underlying ability to pay back the debt and the interest using the income they have generated over time.
The difference between Interest Coverage and Debt Service Ratio is that where on one hand, Interest Coverage Ratio gauges the interest payment ability, Debt Service Coverage includes both interest and payment.
The debt Service Ratio is used by banks or financial institutions that companies approach 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.
When companies have a Debt Service Coverage Ratio of less than 1, it implies they do not have sufficient funds to cover interest and the principal payment.
The formula of Debt Service Coverage Ratio
The 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 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 5 times.
3) Cash Coverage Ratio
The cash Coverage Ratio is another coverage ratio that compares the company’s cash and the annual interest expense that is borne.
This solely compares the company’s liquidity to the interest expense that it has to bear relative to its debt.
The main premise of calculating the cash coverage ratio lies in the realm of assessing if the company has enough liquidity to cover its interest expenses.
The formula for Cash Coverage Ratio
The 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 $25,000. During the year, they accrued an interest expense of $2,500.
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 as many as 10 times.
3) Asset Coverage Ratio
Asset Coverage Ratio is a coverage ratio used to assess if the company has sufficient assets that, if needed, can be sold 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, if 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 that all other liabilities will 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 will be able to pay all of its debt-related obligations without selling off its assets.
Therefore, the company’s overall financial position is considered good, and apparently, there should be no issue in paying back the amount.
This would be a relatively low-risk option from the creditor’s or the lender’s perspective.