Cash coverage ratio
/What is the Cash Coverage Ratio?
The cash coverage ratio is useful for determining the amount of cash available to pay for a borrower's interest expense. It is expressed as a ratio of the cash available to the amount of interest to be paid. To show a sufficient ability to pay, the ratio should be substantially greater than 1:1. The ratio is commonly used by lenders to see if existing borrowers are in financial difficulty, and to determine whether they should loan money to new loan applicants.
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How to Calculate the Cash Coverage Ratio
To calculate the cash coverage ratio, take the earnings before interest and taxes (EBIT) from the income statement, add back to it all non-cash expenses included in EBIT (such as depreciation and amortization), and divide by the interest expense. The formula is:
(Earnings Before Interest and Taxes + Non-Cash Expenses) ÷ Interest Expense
= Cash Coverage Ratio
Example of the Cash Coverage Ratio
The controller of the Anderson Boat Company (ABC) is concerned that the company has recently taken on a great deal of debt to pay for a leveraged buyout, and wants to ensure that there is enough cash to pay for its new interest burden. The company is generating earnings before interest and taxes of $1,200,000 and it records annual depreciation of $800,000. ABC is scheduled to pay $1,500,000 in interest expenses in the coming year. Based on this information, ABC has the following cash coverage ratio:
($1,200,000 EBIT + $800,000 Depreciation) ÷ $1,500,000 Interest Expense
= 1.33 cash coverage ratio
The calculation reveals that ABC can pay for its interest expense, but has very little cash left for any other payments.
Enhancements to the Cash Coverage Ratio
There may be a number of additional non-cash items to subtract in the numerator of the formula. For example, there may have been substantial charges in a period to increase reserves for sales allowances, product returns, bad debts, or inventory obsolescence. If these non-cash items are substantial, be sure to include them in the calculation. Also, the interest expense in the denominator should only include the actual interest expense to be paid - if there is a premium or discount to the amount being paid, it is not a cash payment, and so should not be included in the denominator.
Cash Coverage Ratio Disadvantages
There are several concerns with the cash coverage ratio. They are as follows:
Only shows a single point in time. The cash coverage ratio measures a single moment in time, which is usually as of the end of a reporting period. The outcome might change drastically a few days later, depending on how management decides to use the available cash.
Variances in calculation method. Different lenders use variations on this measurement, which may lead one lender to reject a loan request while another one accepts the same request.