Coverage ratio

Coverage ratio
See also
Operating cash flow ratio Solvency ratios Current portion of long-term debt Debt to total assets ratio Defensive interval ratio Debt management ratio Asset coverage ratio Functions of financial management Activity ratios

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 . 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 .

The formula is :

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

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

Interest 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 .

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, commercial bonds. In risk management, the indicator is used to examine the ability of investment projects to repay their debt through cash flows.

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 . 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.

Examples of Coverage ratio

• Debt Service Coverage Ratio (DSCR): This ratio is used to measure the company’s ability to cover its debt payments from its operating income. It is calculated by dividing the company’s net operating income by its total debt service payments. A high DSCR indicates that the company is able to comfortably pay off its debt obligations.
• Interest Coverage Ratio (ICR): This ratio is used to measure the company’s ability to pay its interest expenses from its operating income. It is calculated by dividing the company’s net operating income by its total interest expenses. A high ICR indicates that the company is able to comfortably pay off its interest expenses.
• Fixed Charge Coverage Ratio (FCCR): This ratio is used to measure the company’s ability to cover its fixed charges from its operating income. It is calculated by dividing the company’s net operating income by its total fixed charges. A high FCCR indicates that the company is able to comfortably pay off its fixed charges.
• Cash Coverage Ratio (CCR): This ratio is used to measure the company’s ability to cover its cash outflows from its operating income. It is calculated by dividing the company’s net operating income by its total cash outflows. A high CCR indicates that the company is able to comfortably pay off its cash outflows.
• Asset Coverage Ratio (ACR): This ratio is used to measure the company’s ability to cover its liabilities from its asset base. It is calculated by dividing the company’s total assets by its total liabilities. A high ACR indicates that the company has a strong asset base to cover its liabilities.

Advantages of Coverage ratio

A coverage ratio is a financial metric used to measure a company's ability to meet its financial obligations. It is an important indicator of a company's solvency and profitability. The following are some of the advantages of coverage ratios:

• Coverage ratios provide information on a company's ability to pay its debts, making them useful for investors and creditors.
• Coverage ratios measure a company's ability to generate profits and cash flow, which can be used to assess the company's financial health.
• Coverage ratios can be used to compare different companies in the same industry and to assess the overall performance of the industry.
• Coverage ratios can provide insight into a company's liquidity, which can help to identify potential problems and opportunities.
• Coverage ratios can be used to evaluate the effectiveness of a company's management in terms of cost control, debt management, and capital structure.

Limitations of Coverage ratio

The following are some of the limitations of the coverage ratio:

• It does not take into account any off-balance sheet items, such as leases or contingent liabilities, which can have a significant impact on a company’s financial position.
• It does not consider the quality of assets and liabilities, or the company's ability to generate future cash flows.
• It is only valid if the company has enough liquidity to repay its debts, so it may not be meaningful if the company is already in a distressed financial situation.
• It is based on historical data, so it may not be a reliable indicator of future performance.
• It does not consider the variability of income and expenses, so it may not provide a comprehensive picture of the company's financial health.

Other approaches related to Coverage ratio

An introduction to other approaches related to Coverage ratio is that they are all measures used to analyze a company's financial health. The following are some additional approaches used in assessing a company's performance:

• Liquidity ratio - measures a company's ability to pay short-term obligations such as current liabilities.
• Debt-to-equity ratio - measures the amount of leverage a company has taken on to finance its operations.
• Operating cash flow ratio - measures the ability of a company to generate cash from its operations.
• Return on assets - measures how profitable a company is relative to its total assets.
• Operating margin - measures the profitability of a company by comparing its operating income to its total revenue.

In conclusion, Coverage ratio is a useful measure of a company's financial health, but other approaches such as liquidity ratio, debt-to-equity ratio, operating cash flow ratio, return on assets, and operating margin can also be used to assess a company's performance.

References

• Arnold, U., & Yildiz, Ö. (2015). Economic risk analysis of decentralized renewable energy infrastructures–A Monte Carlo Simulation approach., Renewable Energy, No 77, p. 227-239
• Bauer R., Hann D. (2010). Corporate environmental management and credit risk
• Gavalas D., Syriopoulos T. (2013). Bank Loan Quality and Credit Risk Exposure: A Multi-criteria Decision Approach to Collateral Selection in Shipping., Economics World, No 1(1), p. 59-86
• Kajananthan R., Velnampy T. (2014). Liquidity, Solvency and Profitability Analysis Using Cash Flow Ratios and Traditional Ratios: The Telecommunication Sector in Sri Lanka., "Research Journal of Finance and Accounting", Vol.5, No. 23, p. 163-171
• Kavussanos M. G., Tsouknidis D. A. (2016) Default risk drivers in shipping bank loans., "Transportation Research Part E: Logistics and Transportation Review", No 94, p. 71-94
• Kirkham R. (2012). Liquidity analysis using cash flow ratios and traditional ratios: The telecommunications sector in Australia., "Journal of New Business Ideas & Trends", No 10.1, p. 1-13

Footnotes

Author: Justyna Banowska