Coverage Ratio

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DEFINITION of 'Coverage Ratio'

A measure of a company's ability to meet its financial obligations. In broad terms, the higher the coverage ratio, the better the ability of the enterprise to fulfill its obligations to its lenders. The trend of coverage ratios over time is also studied by analysts and investors to ascertain the change in a company's financial position. Common coverage ratios include the interest coverage ratio, debt service coverage ratio and the asset coverage ratio.

BREAKING DOWN 'Coverage Ratio'

While comparison of coverage ratios of companies in the same industry or sector will provide valuable insights into their relative financial positions, comparing ratios across companies in different sectors will not prove as useful, since it may be tantamount to comparing apples and oranges.

For example, the interest coverage ratio measures the ability of a company to pay the interest expense on its debt. An energy producer may have an interest coverage ratio of 5, while a utility may have a coverage ratio of 4. This does not automatically imply that the energy producer is more solvent than the utility, since the energy producer may have greater volatility in its earnings and cash flows than the utility, due to fluctuations in oil and gas prices. As well, if the energy company's peers have an average interest coverage ratio of 7, while the utility's peers have an average coverage ratio of 3, the utility may actually be in better shape than the energy producer, especially in relation to their respective peers.

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RELATED FAQS
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