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A coverage ratio is a metric that measures a companyâ€™s ability to pay its financial obligations. Generally, the higher the coverage ratio, the better able the business is to meet its debt obligations.

Itâ€™s best to compare coverage ratios of companies in the same industry or sector of the economy.Â  Coverage ratio comparisons across industries are not useful, as companies in different industries use debt in different ways.

The three most common coverage ratios are: interest coverage ratio, debt coverage ratio and asset coverage ratio.

The interest coverage ratio is calculated by dividing earnings before interest and taxes (EBIT) by the interest expenses from the same accounting period. Generally, a ratio of 1.5 or better is preferred.Â  This means that the company earns one and a half times what it needs to pay its interest obligations.

The debt coverage ratio is calculated by dividing net income by the sum of total principal and interest payments.Â  A ratio below 1 means the company is not earning enough to pay off debt principal balances owed to its creditors.Â

The forward-looking asset coverage ratio focuses on a companyâ€™s long-term prospects of paying its debts. The more assets a company has in relation to its debt, the better its chances are of paying off its debts. The asset coverage ratio formula is:

[(Total Assets â€“ Intangible Assets) â€“ (Current Liabilities â€“ Short term obligations)]/Total Debt

There is no standard for an asset coverage ratio as it varies depending on the industry.

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