Coverage Ratio - Explained
What is a Coverage Ratio?
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Table of ContentsWhat is a Coverage Ratio?Types of Coverage RatiosInterest coverage ratioDebt service coverage ratioCash coverage ratioAsset coverage ratioWhy is Coverage Ratio Important?Academic Research on Coverage Ratio
What is a Coverage Ratio?
Coverage ratio refers to a group of financial ratios that measures the ability of the company to meet its financial obligations such as debt, dividends, or interest. A higher ratio is an indication that the company has a greater ability to pay its debt interest or dividends. Lower indicates less ability. The coverage ratio is most common among lenders or creditors. They use it to determine a prospective borrowers financial position. Investors, as well as financial analysts, use it to gauge a company's financial risk.
Types of Coverage Ratios
Interest coverage ratio
This ratio determines the company's ability to pay the interest that the loan it took from the bank generates. It is also referred to as time interest earned. The ratio evaluates how many times a company can pay the interest expenses on the debts from its operating income. Interest coverage of about 1.5 is considered to be a minimum acceptable ratio. On the other hand, that which is below 1.5 signals a default risk. In this case, the chances of lenders refusing to offer a loan to the company are high.
This ratio determines the ability of the company to service its debts from its earnings. It includes payment of both interest and principle. The calculation is done when a company acquires a loan from a bank or other financial institutions that provide loans.
The cash coverage ratio determines the company's ability to pay its interest expense using its cash balance. The ratio is for comparing the cash balance of the company to its annual interest expense. Unlike interest coverage ratio focuses on comparing income, this metric compares cash in hand only.
This coverage ratio refers to the company's ability to meet debt obligations using its assets. It does an evaluation of assets to determine if by selling them, they can be able to cover a company's debt. It is the industry that determines the acceptable asset level coverage. The assets may include things such as machinery, land, inventory, among others. Note that in the event that a company is unable to service its liabilities, it is usually compelled to sell its assets. This situation increases the possibility of a firm becoming bankrupt. Filing for bankruptcy decreases returns for its investors. It is, therefore, for investors to do a risk assessment of the company they intend to invest in.
Why is Coverage Ratio Important?
- It helps in the preparation of financial models to determine the debt capitals amount available for a company acquisition.
- It is an important financial ratio when it comes to the viewpoint of both long term lenders and creditors. They use coverage ratio to decide whether or not to offer loans or credit to a firm.