Coverage ratio

Coverage ratio
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Coverage ratio informs about the financial situation of the company. Used in the solvency analysis and profitability. Whether the surveyed organization has the ability to service its debts and whether it is able to meet its obligations. The higher the coverage ratio, the better the financial situation of the company. The most information analysts can get from analysis of trends of coverage ratio over time.

Three main coverage ratios

There are three main coverage ratios:

• Interest coverage ratio - shows whether company is able to pay interest related to its debt
• Debt service coverage ratio - describes whether company is able to pay all the debts
• Asset coverage ratio - as above, but calculation based on balance sheet

Interest coverage ratio

Interest coverage ratio it is a solvency indicator. It expresses the coverage of interest expenses by operating income before depreciation [1]. The interest coverage ratio below 1 will be indicative of a situation in which the company does not have sufficient cash to pay interest. The interest coverage ratio is also one of the traditional indicators used to calculate the company's financial liquidity [2].

The formula is [3]:

$$ICR =\frac{EBIT}{I}$$

Where:

• ICR - Interest Coverage Ratio
• EBIT - earnings before interest and income tax or Net Operating Profit + Interest + Tax
• I - Annual Interest

Interest coverage ratio or Cash flow-interest coverage

Interst coverage ratio is one of the traditionals indicator. Which are calculated on the basis of data from the profit and loss account and financial statements. Cash flow interest coverage ratio may be a more realistic representation of the financial situation of the company and its ability to pay off annual interest [4].

Debt service coverage ratio

Debt service coverage ratio (DSCR ) is the relation of gross cash flow and debt service. DSCR is conventional indicator when enterprise has borrowings on its balance sheet. For example comercial bonds. In risk management, the indicator is used to examine the ability of investment projects to repay their debt through cash flows. [5]

The formula is : DSCR = Cash flow of Period + Interest Payment / Repayment + Interest Payment of Period

Where :

• DSCR - Debt Service Cover Ratio

Ratio of 1.0 is indicates total coverage of debt service. The value of the indicator below 1 should warn against the solvency problems of the company.

Asset coverage ratio

Asset coverage ratio (ACR) measures the ability of an enterprise to pay its liabilities with its assets. If the value of assets exceeds the value of liabilities, the index will take the value above 1 [6]. Often, this indicator is overstated because assets are included in the company's balance sheet in the book value. Asset coverage ratio with a value below 1 will appear more often in a service enterprise than a production or commercial enterprise. The formula is:

Asset coverage ratio (ACR) = ((Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)) / Total Debt

Where:

• Current Liabilities - total trade payables and other payables that are payable within 12 months.
• Short-term Debt - with a maturity below 1 year, consists of short-term bank loans or commercial paper.

Usage of coverage ratio

Coverage ratios give information how much the enterprise is in debt. To creditors, especially for banks these are important indicators informing whether a given company will be able to pay off its debts in time. Investors and managers want to know how big the risk is that the company will go bankrupt.

Footnotes

1. Bauer R., Hann D., 2010, p. 11
2. Kirkham R., 2012, p. 1
3. Kirkham R., 2012, p. 3
4. Kajananthan R., Velnampy T. 2014, p. 165
5. Arnold U., Yildiz Ö., 2015, p. 228
6. Gavalas D., Syriopoulos T. 2013, p. 70

Author: Justyna Banowska