What is Coverage Ratio?

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Coverage Ratio Formulas

Let us discuss each of the coverage ratios along with its formula. Analysts use the below-mentioned ratios to determine the firm’s position for its debt obligations:

#1 – Interest Coverage

It is used to determine how well a company can pay off its interest in debt using its earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read more. It is also known as Times Interest Earn RatioTimes Interest Earn RatioTimes interest earned is the ratio between earnings before interest and taxes and the interest expenses of the company over that specific period; it helps in determining the liquidity position of the company by determining whether it is in a comfortable position to pay interest on its outstanding debt.read more.

Coverage Ratio Formula

Interest Coverage = EBIT / Internet Expense

#2 – Debt Service Coverage

This ratio determines the company’s position to pay off its entire debt from its earnings. The company’s ability to repay the entire principal plus interest obligation of debt in the near term is measured by this ratio; if this ratio is more than 1, than the company is in a comfortable position to repay the loan.

Debt Service Coverage= Operating Income / Total Debt

#3 – Asset Coverage

This ratio is similar to the Debt Service ratio, but instead of Operating IncomeOperating IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business.read more, it will see whether debt can be paid off from its assets. If the firm is not able to generate enough income to repay debt, then whether the assets of the company such as land, machinery, inventory, etc. can be sold off to give back the loan amount. Usually, this ratio should be more than 2.

Asset Coverage = (Tangible Asset – Short Term Liabilities)/Total Debt

#4 – Cash Coverage

Cash CoverageCash CoverageCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets.read more is used to determine whether a firm can pay off its interest expense from available cash. It is similar to the Interest Coverage, but instead of Income, this ratio will analyze how much cash available to the firm. Ideally, this ratio should be greater than 1.

Cash Coverage = (EBIT + Non Cash Expense)/Interest Expense

Examples

Example #1

Let’s say a firm’s total “Operating Income” (EBIT) for the given period is $1,000,000, and its total outstanding principal debt is $700,000. The firm is paying 6% interest on the debt.

So, its total interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more for giving period =debt * interest rate

=700,000*6% = $42,000

  • Interest Coverage

  • Debt Service Coverage

total debt payable (Principal plus interest)

  • Asset Coverage

Let’s say the firm is having $900,000 of tangible assetsTangible AssetsTangible assets are assets with significant value and are available in physical form. It means any asset that can be touched and felt could be labeled a tangible one with a long-term valuation.read more and its short-term liabilities are $100,000

  • Cash Coverage

And non-cash expenses are $100,000

Example #2

Let’s take a practical example of an Indian company which is having quite a high amount of debt in its balance sheet. Bharti Airtel is an Indian telecom company which is known as a very high debt-ridden company because of high CapEx requirement in this industry

Below are some of the basic data for Bharti Airtel:

Data in Rs Mil.

Source: Annual Reports and www.moneycontrol.com

In the below graph, we can analyze the trend of coverage ratios for Bharti Airtel:

As we can see that over the years, these ratios are going down. It is because its debt has increased over the years, and EBIT has gone down because of margin pressure and entry of “Reliance Jio” into the market. If this continues in the future, then Bharti Airtel could be in a bad position regarding its debt, or maybe it has to sell off its assets to repay the loan.

Use of Coverage Ratios

Limitations

  • There may be the case that for a given period, a firm has taken more debt, but its effect will come into the next periods. Also, seasonality can be a factor that hides or distort these ratios.Some companies have higher CapEx requirements, so their debt size will be more than other companies.That can be cases when companies change their accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level.read more, and because of that, these ratios can be affected.We should not use these ratios as stand-alone. While checking firm health, other ratios, such as liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more or profitability ratios, also need to be analyzed alongside to make the decision.

This article has been a guide to what is Coverage Ratio? Here we discuss the top 4 types of Coverage Ratio including interest coverage, debt service coverage, cash coverage, and asset coverage, along with practical examples. You can learn more about from the following articles –

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