Coverage ratio definition
/What is a Coverage Ratio?
A coverage ratio measures the ability of a business to pay its debts in a timely manner. Coverage ratios are commonly employed by creditors and lenders, both for their existing customers and new customers applying for credit. The ratios may be used internally, though usually only when loan covenants require that a business must maintain a certain minimum ratio or else face a loan cancellation.
A coverage ratio could provide a narrow focus on just the ability to pay back interest on a loan (the interest coverage ratio) or examine the ability to pay back both the interest and scheduled principal payments on a loan (the debt service coverage ratio). The latter type of measurement is preferable, since it provides the most detailed analysis of whether a business can fulfill its debt obligations.
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Types of Coverage Ratios
There are several types of coverage ratios, each of which addresses a slightly different aspect of the debt-paying ability of a borrower. We note several coverage ratios below.
Asset Coverage Ratio
The asset coverage ratio measures how well an organization can pay its debts. Though expressed as a ratio, the asset coverage ratio really requires a set of formulation steps, which are as follows:
Extract from the general ledger the ending balances of all assets.
Subtract from the total of these assets the amounts recorded on the books for any intangible assets. This deduction is made on the assumption that intangible assets cannot be converted into cash; if this is not the case, retain those intangibles that have a conversion value.
Extract from the general ledger all current liabilities, not including those liabilities associated with short-term debt.
Subtract the net liabilities figure in step 3 from the net asset figure derived in step 2. The result should be the amount of assets available for use to pay down debts.
Divide the net amount derived in step 4 by the ending book balance of all debt outstanding. This includes the amount of any capital leases outstanding.
Debt Service Coverage Ratio
The debt service coverage ratio measures the ability of a revenue-producing property to pay for the cost of all related mortgage payments. To calculate the ratio, divide the net annual operating income of the property by all annual loan payments for the same property. The formula is:
Net Annual Operating Income ÷ Total of Annual Loan Payments
Interest Coverage Ratio
The interest coverage ratio is the most basic of the coverage ratios. It measures the ability of a company to pay the interest on its outstanding debt. The formula for this ratio is to divide earnings before interest and taxes (EBIT) by the interest expense for the measurement period. The calculation is:
Earnings before interest and taxes ÷ Interest expense
How to Evaluate a Coverage Multiple
There is no particular coverage multiple that is specifically considered good or bad. In general, the higher the ratio, the better the probability that a company will be able to pay its debts. If a ratio is less than 1:1, this is a strong indicator of impending payment problems. The best way to examine a coverage ratio is to plot it on a trend line over a long period of time; if the trend is declining, this can be an indicator of future problems, even if the ratio is currently high enough to indicate a reasonable level of liquidity. The ratio can also be compared to the same calculation for competitors, to see how the targeted business is operating in relation to its peers.
Coverage ratios should be evaluated in concert with the volatility of company cash flows. If cash flows fluctuate a great deal over time, even a high coverage ratio may not provide an adequate indication of the ability to pay. Conversely, if company cash flows are extremely steady and reliable, a much lower coverage ratio might still provide a creditor or lender with some confidence concerning repayment.