The ability to separate companies with a healthy amount of debt from those that are overextended is one of the most important skills an investor can develop. Most businesses use debt to help finance operations, whether it’s buying new equipment or hiring additional workers. But relying too much on borrowing will catch up with any business. For example, when a company has difficulty paying creditors on time, it may have to sell off assets, which puts it at a competitive disadvantage. In extreme cases, it may have no choice but to file for bankruptcy.

Coverage ratios are a useful way to help gauge such risks. These relatively easy formulas determine the company’s ability to service its existing debt, potentially sparing the investor from heartache down the road.

The most widely used coverage ratios include the interest, debt-service and asset coverage ratios.

Interest Coverage Ratio

The basic concept behind the interest coverage ratio is pretty straightforward. The more profit a company generates, the greater its ability to pay down interest. To arrive at the figure, simply divide the earnings before interest and taxes (EBIT) by the firm’s interest expense for the same period.

Interest coverage ratio = EBIT / Interest expense

A ratio of 2 means the company earns twice as much as it has to pay out in interest. As a general rule, investors should lean toward companies with an interest coverage ratio – otherwise known as the “times interest earned ratio” – of at least 1.5. A lower ratio usually indicates a firm that’s struggling to pay off bondholders, preferred stockholders and other creditors.

Debt-Service Coverage Ratio

While the interest coverage ratio is widely used, it has an important shortcoming. In addition to covering interest expenses, businesses usually have to pay down part of the principal amount each quarter, too.

The debt-service coverage ratio takes this into account. Here, investors divide net income by the total borrowing expense – that is, principal repayments plus interest costs.

Debt-service coverage ratio = Net income / (Principal repayments + Interest expense)

A figure under 1 means the business has a negative cash flow – it’s actually paying more in borrowing expenses than it’s bringing in through revenue. Therefore, investors should look for businesses with a debt-service coverage ratio of at least 1 and preferably a little higher to ensure an adequate level of cash flow to address future liabilities.

  • Practical Example: To see the potential difference between these two coverage ratios, let’s look at fictional company Cedar Valley Brewing. The company generates a quarterly profit of $200,000 (EBIT is $300,000) and corresponding interest payments of $50,000. Because Cedar Valley did much of its borrowing during a period of low interest rates, its interest coverage ratio looks extremely favorable.

Interest coverage ratio = 300,000 / 50,000 = 6

The debt-service coverage ratio, however, reflects a significant principal amount the company pays each quarter totaling $140,000. The resulting figure of 1.05 leaves little room for error if the company’s sales take an unexpected hit.

Debt-service coverage ratio = 200,000 / 190,000 = 1.05

Even though the company is generating a positive cash flow, it looks more risky from a debt perspective once debt-service coverage is taken into account.

Asset Coverage Ratio

The aforementioned ratios compare a business’ debt in relation to its earnings. Therefore, it’s a good way to look at an organization’s ability to cover liabilities today. But if you want to forecast a company’s long-term profit potential, you have to look closely at the balance sheet. In general, the more assets the company has when compared to its total borrowings, the more likely it will be to make payments down the road.

The asset coverage ratio is based on this idea. Basically, it takes the company’s tangible assets after accounting for near-term liabilities, and divides the remaining number by the outstanding debt.

Asset coverage ratio = [(Total assets – Intangible assets) – (Current liabilities – Short-term debt obligations)] / Total debt outstanding

Whether the resulting figure is acceptable depends on the industry. For example, utilities should typically have an asset coverage ratio of at least 1.5, while the traditional threshold for industrial companies is 2.

  • Practical Example: This time let’s look at JXT Corp., which makes factory automation equipment. The company has assets of $3.6 million of which $300,000 are intangible items such as trademarks and patents. It also has current liabilities of $600,000, including short-term debt obligations of $400,000. The company’s total debt equals $2.3 million.

Asset coverage ratio = [(3,600,000 – 300,000) – (600,000 – 400,000)] / 2,300,000 = 1.3

At 1.3, the company’s ratio is well below the typical threshold. By itself, this shows that JXT has insufficient assets to draw upon, given its substantial amount of debt.

One limitation of this formula is that it relies on the book value of a business’s assets, which will often vary from its actual market value. To obtain the most reliable results, it usually helps to use multiple metrics to evaluate a corporation rather than relying on any single ratio.

Evaluating Businesses

Investors can use coverage ratios in one of two ways. First, you can track changes in the company’s debt situation over time. In cases where the debt-service coverage ratio is barely within the acceptable range, it may be a good idea to look at the company’s recent history. If the ratio has been gradually declining, it may only be a matter of time before it falls below the recommended figure.

Coverage ratios are also valuable when looking at a company in relation to its competitors. Evaluating similar businesses is imperative, because an interest coverage ratio that’s acceptable in one industry may be considered risky in another field. If the business you’re evaluating seems out of step with major competitors, it’s often a red flag.

The Bottom Line

Over the long run, excessive reliance on debt can wreak havoc on a business. Tools such as the interest coverage ratio, debt-service coverage ratio and asset coverage ratio can help you determine up front whether a company can pay its creditors in a timely manner.

Related Articles
  1. Investing Basics

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  2. Fundamental Analysis

    Using Enterprise Value To Compare Companies

    Learn how enterprise value can help investors compare companies with different capital structures.
  3. Investing Basics

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  4. Markets

    How To Use Price-To-Sales Ratios To Value Stocks

    Take a look at how this effective ratio can be influenced by certain critical factors.
  5. Investing Basics

    How To Find P/E And PEG Ratios

    If these numbers have you in the dark, these easy calculations should help light the way.
  6. Investing

    A Look at 6 Leading Female Value Investors

    In an industry still largely predominated by men, we look at 6 leading female value investors working today.
  7. Term

    What Is Financial Performance?

    Financial performance measures a firm’s ability to generate profits through the use of its assets.
  8. Stock Analysis

    The Biggest Risks of Investing in FireEye Stock

    Examine the current state of FireEye, Inc., and learn about some of the biggest risks of investing in this cybersecurity company's stock.
  9. Stock Analysis

    The Biggest Risks of Investing in Gilead Stock

    Examine the current position of Gilead Sciences, Inc., and learn the major risks for investors considering buying Gilead stock.
  10. Fundamental Analysis

    Create a Monte Carlo Simulation Using Excel

    How to apply the Monte Carlo Simulation principles to a game of dice using Microsoft Excel.
  1. Which types of coverage ratios should I look at when deciding to invest in a company?

    Investors are less likely to rely on coverage ratios than large debtors such as banks. That said, there is value in understanding ... Read Full Answer >>
  2. What is the difference between interest coverage ratio and TIE?

    There is no substantive difference between the interest coverage ratio and times interest earned (TIE); these are two names ... Read Full Answer >>
  3. How do I use discounted cash flow (DCF) to value stock?

    Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
  4. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  5. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  6. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!