What is a Coverage Ratio
A coverage ratio is a measure of a company's ability to service its debt and meet its financial obligations. The higher the coverage ratio, the easier it should be to make interest payments on its debt or pay dividends. The trend of coverage ratios over time is also studied by analysts and investors to ascertain the change in a company's financial position.
BREAKING DOWN Coverage Ratio
Coverage ratios can be used to help identify companies in a potentially troubled financial situation – though low ratios are not necessarily an indication that a company is in financial difficulty. Many factors go into determining these ratios and a deeper dive into a company's financial statements is often recommended to ascertain a business' health. Net income, interest expense, debt outstanding and total assets are just a few examples of the financial statement items that should be examined. To ascertain whether the company is still a going concern, one should look at liquidity and solvency ratios, which assess a company's ability to pay short-term debt, i.e. convert assets into cash.
While comparing the coverage ratios of companies in the same industry or sector can provide valuable insights into their relative financial positions, doing so across companies in different sectors is not as useful, since it might be like to comparing apples and oranges. Common coverage ratios include the interest coverage ratio, debt service coverage ratio and the asset coverage ratio. These coverage ratios are summarized below:
Interest Coverage Ratio
The interest coverage ratio measures the ability of a company to pay the interest expense on its debt. The ratio, also known as the times interest earned ratio, is defined as a company's earnings before interest and taxes (EBIT) divided by interest expense. An interest coverage ratio of two or higher is generally considered satisfactory.
Debt Service Coverage Ratio
The debt service coverage ratio measures how well a company is able to pay its entire debt service. Debt service includes all principal and interest payments due to be made in the near term. The ratio is defined as net operating income divided by total debt service. A ratio of one or above is indicative that a company generates sufficient earnings to completely cover its debt obligations.
Asset Coverage Ratio
The asset coverage ratio is similar in nature to the debt service coverage ratio, but looks at balance sheet assets instead of comparing income to debt levels. The ratio is defined as a company's total tangible assets — such as land, buildings, machinery and inventory — minus any short-term liabilities divided by its total debt outstanding. As a rule of thumb, utilities should have an asset coverage ratio of at least 1.5, and industrial companies should have an asset coverage ratio of at least 2.