Updated July 24, 2023
Definition of Coverage Ratio
A company has certain fixed payments to be made during a year, such as the interest on debt and the principal repayment of the same, a coverage ratio measures its capacity of being in a position to pay off such liabilities from the profit it is generating over a given period of time, and as the name suggests, it is a measure of how much of the liabilities are covered while how much is uncovered and at risk of default.
It is a ratio of the profits to the liabilities. Therefore if the profits are multiple times the liabilities, then the company is in a good position. The chances of default are almost negligible, but if the company has a coverage ratio of less than 1, that implies that the company is not earning enough to be in a position to pay off the liabilities it is foreseeing. This gives a negative signal to the investor community and may lower the company’s market stock prices.
Types of Coverage Ratio
Types of coverage ratios are defined as to which layer of financial obligations can the company meet. We have the following types:
1. Interest Coverage Ratio
This measures the proportion of profits that cover the interest expense of the company. Therefore, we take up a profit figure that is prior to the charging of interest, such as EBIT or EBITDA. However, EBIT is a more appropriate measure because it is after charging depreciation and amortization and therefore gives the amount of profit that can actually be used to pay off the interest.
2. Debt Service Coverage Ratio
Unlike the Interest coverage ratio, DSCR considers the entire amount of debt to be repaid in the given period of time and then compares it with the profit metric to see how much coverage is available to the company.
- Total debt to service includes principal repayments, interest payable and lease payments.
- Net operating income is the adjusted EBITDA, i.e. Operating Revenue – Operating Expenses.
3. Asset Coverage Ratio
Instead of looking at the profits, it looks at the amount of assets available, which can be disposed of off to pay off the debts of the company. This measure is not very popular for going concern companies but used at the time of liquidation of companies.
There can be many more ratios, one of which was referred to in the interest coverage ratio, known as EBITDA to interest coverage and other ratios such as preferred dividend coverage ratio or loan life coverage ratios. However, these are a little less popular and therefore not much in use.
Example
Suppose a company has an EBIT of $30 million while the depreciation and amortization are $50 million. The debt that the company has to pay off this year is $50 million, while the total debt is $200 million & interest is charged at the rate of 5% p.a.
Interest Expenses are calculated as:
- Interest Expenses = 0.05 x 200
- Interest Expenses = $10 million
Interest Coverage Ratio is calculated using the formula given below
Interest Coverage Ratio= EBIT/ Interest Expense
- Interest Coverage Ratio = 30 / 10 = 3
DSCR is calculated as:
- DSCR = (30 + 50) / (50 + 10)
- DSCR = 1.33
As both the ratios are greater than 1, the company seems to be in a good financial position to fulfill its liabilities.
Interest Service Coverage Ratio and Debt Service Coverage Ratio
As described above, the interest coverage ratio only looks at the interest portion of the debt while the DSCR looks at interest, principal and lease payments due to be paid during a given period of time.
The numerator needs to be comparable to the expense that is being covered, so in the case of the interest coverage ratio, we use EBIT, while in the case of DSCR, we use adjusted EBITDA, i.e. the net operating income in the numerator.
The interest coverage ratio may show that the company is in a good position; however, it may not truly be because it doesn’t have enough to pay off the principal or lease portions of debt. Therefore if a company has both ratios of greater than 1, it is definitely in a better position than one being less than 1
Advantages and Disadvantages
Below are the advantages and disadvantages:
Advantages
- It determines the movements in the position of a company from one period to another. If the ratios are on an increasing trend, then the profits of the company are consistently outperforming the financial liabilities and vice versa. It is also a signal of improvement or decline in the company’s financial position.
- As compared to its competitors, the company may be in a better or worse position to service its debt and therefore, this comparison is a key metric in investment decision-making for prospective investors.
Disadvantages
- Both EBIT and EBITDA are measured before accounting for tax expenses. Therefore, the amount of profit considered is overstated because not an entire portion of this profit is available to the debt holders; some portion will be used for payment of taxation.
- Accounting profits are not cash flow measures and can be manipulated by accounting practices. Therefore, It can be manipulated too, so the investor needs to be more careful while looking at the coverage ratios.
Conclusion
Overall, coverage ratios are popular measures to understand whether a company is in a good position to pay off its financial liabilities or not. If these ratios are greater than 1, then the company is earning more profit than the liabilities, but if they are below 1, then the company is not financially sound.
An investor should always investigate these ratios before making an investment decision so that he doesn’t invest in a company that might not be in a position to pay its liabilities because that investment would make investor losses in the long run, if not immediately.
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