What is the Coverage Ratio
Coverage ratio is a group of financial ratios that measures the company’s ability to repay its debt obligations. The higher coverage ratio indicates the greater company’s ability to repay debt with a relative factor in each coverage ratio.
The coverage ratio reflects how easily the company can cover its financial obligations such as interest payments, the total debt, and other interest expenses. Thus, the creditors and lenders use these coverage ratios to determine the company’s financial health before lending them.
The most common coverage ratios to measure the company’s ability to repay its debt includes:
- Interest coverage ratio: To measure available income for interest payments.
- Debt service coverage ratio: To measure available cash flow to repay the debt services.
- Asset coverage ratio: To measure the ability to pay off its debt by liquidating its tangible assets.
- Cash debt coverage ratio: To measure available cash to repay interest expenses.
Normally, the coverage ratio value of 1 (in any coverage ratio) means the company has the relative factors (such as cash or income) exactly equal to the liabilities obligations. In other words, the company must allocate all of its relative factors to meet its obligations.
Interest Coverage Ratio
Interest coverage ratio measures the number of available income for interest payments (and other fixed charge obligations) also known as the Time Interest Earned Ratio. The interest coverage ratio (ICR) is the comparison between the earnings before interests and taxes (EBIT) and the company’s interest expense within a year, or the following interest coverage ratio formula:
- ICR = EBIT / Interest expenses
The higher number of interest coverage ratio, the higher profits left to repay interest expenses and vice versa. For example, when the ICR is less than 1 means the company has less than $1 of the operating profit to pay $1 of interest expenses.
Debt Service Coverage Ratio
Debt service coverage ratio measures the available cash flow to repay the company’s liabilities, also known as the debt coverage ratio. The debt service coverage ratio is a comparison between net operating income and debt service, or the following debt service coverage ratio formula:
- DSCR = EBITDA / Total debt service
The higher value of the debt service coverage ratio, the higher ability to repay debt with the available cash flow from the operating income. For example, when the DSCR value of 1.00 means the operating income is exactly equal to the debt service.
Asset Coverage Ratio
Asset coverage ratio measures the company’s ability to pay off its debt by liquidating its tangible assets. The asset coverage ratio is a comparison between the company’s tangible assets with the total debt, or the following asset coverage ratio formula:
- ACR = [(Total assets – Intangible assets) – (Current liabilities – Short-term debt)] / Total debt
The higher the asset coverage ratio, the higher the company’s ability to cover its debt. For example, the ACR of 4 means if the company is liquidated now, the company is able to repay the short-term and long-term debt 4 times.
Cash Coverage Ratio
Cash coverage ratio measures the number of dollars of operating cash available to pay each dollar of interest expenses and other fixed charges. The cash coverage ratio is a simple comparison between cash and equivalents on hand to the interest expense, as the following cash coverage ratio formula:
- CCR = (Cash + Cash equivalent) / Interest expenses
The higher value of the cash coverage ratio, the more cash available for the interest expenses. When the CCR value is more than 1 means the company’s total cash is available more than the interest expenses.
