What Is a Coverage Ratio?

What Is a Coverage Ratio?

Let me explain what a coverage ratio is—it's one of several solvency ratios that focus on the long-term financial stability of businesses. Essentially, a coverage ratio shows whether a company can service its debt and meet other financial obligations, such as paying dividends.

If you see a high coverage ratio, it means the company is likely to handle its future interest payments and all its financial commitments without issue. Analysts and investors like you might track changes in a company's coverage ratio over time to get a clear picture of its financial position.

Understanding Coverage Ratios

You can use coverage ratios in various ways as an investor. For instance, they help identify companies that might be in a troubled financial situation. A high coverage ratio is a sign that the company is likely to meet all its financial obligations, but remember, a low ratio doesn't always mean the company is in difficulty—sometimes you need to dig deeper into the financial statements for a better understanding of the business's health.

These ratios are also great for comparing one company to its competitors. When you evaluate coverage ratios of companies in the same industry or sector, you gain useful insights into their relative financial positions. Just make sure you're only comparing similar businesses; what's an acceptable coverage ratio in one industry could be risky in another. If a business you're looking at seems out of step with its major competitors, consider that a potential red flag.

Types of Coverage Ratios

There are several types of coverage ratios you should know about, including the interest coverage ratio, debt service coverage ratio, and asset coverage ratio. Let me break them down for you.

Interest Coverage Ratio

The interest coverage ratio measures a company's ability to pay the interest expenses on its debt. It's also known as the times interest earned (TIE) ratio, and you calculate it as EBIT divided by interest expense, where EBIT is earnings before interest and taxes. Generally, an interest coverage ratio of two or higher is considered satisfactory.

Debt Service Coverage Ratio

The debt service coverage ratio (DSCR) assesses how well a company can pay its entire debt service, which includes all principal and interest payments due soon. You define it as net operating income divided by total debt service. A ratio of one or above shows that the company generates enough earnings to cover its debt obligations completely.

Asset Coverage Ratio

The asset coverage ratio is similar to the debt service coverage ratio but focuses on balance sheet assets instead of income compared to debt levels. You calculate it as total assets minus short-term liabilities, divided by total debt, where total assets include tangibles like land, buildings, machinery, and inventory. As a rule of thumb, utilities should aim for at least 1.5, and industrial companies at least two.

Other Coverage Ratios

You'll also encounter other coverage ratios that analysts use, though they're not as common. The fixed-charge coverage ratio measures a firm's ability to cover fixed charges like debt payments, interest, and equipment leases, showing how well earnings cover these expenses—banks often check this when deciding on loans.

The loan life coverage ratio (LLCR) estimates a firm's solvency by dividing the net present value of money available for debt repayment by the outstanding debt amount. The EBITDA-to-interest coverage ratio assesses financial durability by checking if a company is profitable enough to pay interest expenses.

The preferred dividend coverage ratio measures the ability to pay required preferred dividend payments, which are fixed unlike common stock dividends. The liquidity coverage ratio (LCR) is the proportion of highly liquid assets held by financial institutions to meet short-term obligations, acting as a stress test for market shocks.

Finally, the capital loss coverage ratio expresses the difference between an asset’s book value and sale amount relative to nonperforming assets being liquidated, indicating regulatory assistance for transactions.

Examples of Coverage Ratios

To illustrate the differences, consider a fictional company, Cedar Valley Brewing. It generates a quarterly profit of $200,000, with EBIT at $300,000 and interest payments of $50,000. For the interest coverage ratio, it's $300,000 divided by $50,000, which equals 6.0— that's favorable because borrowing happened during low interest rates.

However, the debt-service coverage ratio accounts for a significant principal amount, totaling $190,000 in debt service ($140,000 principal plus $50,000 interest). So, $200,000 divided by $190,000 equals 1.05, which leaves little room for error if sales drop. Even with positive cash flow, the company looks riskier from a debt perspective here.

What Is a Good Coverage Ratio?

A good coverage ratio depends on the industry, but typically, you and other investors look for at least two. This level indicates the company can likely make all future interest payments and meet its obligations.

What Is Coverage Ratio Also Known As?

The coverage ratio is also known as the interest coverage ratio or the times interest earned (TIE) ratio.

Is the Interest Coverage Ratio the Same as the Times Interest Earned Ratio?

Yes, the interest coverage ratio is the same as the times interest earned (TIE) ratio—they both measure a company's ability to cover interest expenses with operating income.

The Bottom Line

In summary, the coverage ratio evaluates how capable a company is at paying its debts with current income. Lenders, investors, and creditors use it to understand a company's financial situation and assess risk for future borrowing. A good ratio suggests the company can meet its obligations, but the exact figure varies by industry.