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.
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.
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.
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.