A:

Coverage ratios focus on a company’s ability to manage its debt, while the levered free cash flow to enterprise value ratio is primarily a leverage or equity multiplier valuation. There is not one specific coverage ratio, but several. It is important for investors to be able to determine if a company has a level of debt that exceeds a safe amount and is potentially problematic. It is a normal practice for a business to use debt as a means of financing operations, but if a company utilizes too much debt, it may find it difficult to manage the debt load. Coverage ratios enable investors and analysts to determine how capable a company is of covering its debt obligations. A higher coverage ratio means a company has a greater ability to manage and pay off its outstanding debt. Coverage ratios with the most widespread use include the asset coverage ratio, the interest coverage ratio and the debt-service coverage ratio.

The asset coverage ratio provides investors with the ability to understand a company’s potential to generate sufficient profit from its existing assets to cover its debt. The idea behind this ratio is that a company with more assets than total borrowings is more likely to pay off its obligations at a future time. The asset coverage ratio subtracts a company’s near-term liabilities from its tangible assets, and then divides the total by the company’s debt.

The interest coverage ratio divides a company’s earnings before interest and taxes, or EBIT, by its interest expenses for the same time period. A general rule for investors and analysts is that a company's interest coverage ratio should be 1.5 or higher. Lower ratios are an indication a company may be having difficulty servicing its debt.

The debt-service coverage ratio makes up for a flaw in the interest coverage ratio; it does not take into account that businesses must pay down on principal quarterly. The formula for the debt-service ratio is the company’s net income divided by the total cost of its principal repayments plus interest expenses. Investors prefer debt-service ratios higher than the minimum acceptable level of 1.

The levered free cash flow to enterprise value ratio, or LFCF/EV, is a different type of valuation metric, commonly used to identify undervalued companies. These are companies with a levered free cash flow amount greater than the enterprise value of the company, resulting in a higher ratio. The LFCF/EV is a combination of two parts, levered free cash flow and enterprise value.

Levered free cash flow is free cash flow available once the interest on outstanding debt is paid. This number is significant because it is not a figure that can be easily manipulated on a company’s financial statements. Enterprise value is the total value of a company, including all sources of ownership, such as preferred shares, debt outstanding and market capitalization. The final figure subtracts cash holdings. The comparison of free cash flow to enterprise value provides an alternative valuation of a company that can then be compared to the company's valuation by market capitalization or other basic fundamental valuation metrics.

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