Coverage ratios
/What are Coverage Ratios?
Coverage ratios are used to evaluate the ability of a business to meet its debt obligations. These ratios are most commonly used by lenders and creditors to review the finances of a prospective or current borrower. Coverage ratios compare either income or the amount of assets that can be liquidated to portions or all of a debt obligation. If the resulting ratio is less than 1:1 for an income comparison, then the debt load cannot be supported. A higher ratio is typically needed when comparing assets to debt, since the liquidation value of assets may be low. The most common coverage ratios are noted below.
Interest Coverage Ratio
The interest coverage ratio only addresses the ability of an organization to pay the interest expense associated with its outstanding debt. It is not concerned with paying back the debt itself, or any other fixed charges. The calculation is earnings before interest and taxes, divided by interest expense. The ratio must be at least 1:1, but that is the bare minimum. A ratio of 2:1 is considered to be more representative of a financially healthy borrower. The calculation is as follows:
Earnings before interest and taxes ÷ Interest expense = Interest coverage ratio
Debt Service Coverage Ratio
The debt service coverage ratio links the cash flows from a revenue-generating property to the interest and principal payments associated with that property. This is a highly targeted measurement, and so is usually only applicable to specific real estate properties. The formula is net annual operating income, divided by the total of annual loan payments. The ratio must be greater than 1:1, or the income property cannot generate sufficient funds to pay off the associated debt. The formula is as follows:
Net Annual Operating Income ÷ Total of Annual Loan Payments = Debt service coverage ratio
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Asset Coverage Ratio
The asset coverage ratio takes a different approach to coverage. Instead of focusing on the ability of earnings to pay off debt, this ratio looks at the proportion of assets to debt, on the assumption that assets must be liquidated in order to provide the necessary funds to pay off a debt balance. The formula is to divide the net amount of tangible assets not needed to pay off current liabilities by the current balance of loans outstanding. A ratio higher than 1:1 is useful, since one must assume that some assets (such as inventory) cannot be liquidated on a rush basis and still generate their book values in cash.
Evaluation of Coverage Ratios
Of the ratios described here, the interest coverage ratio is the weakest, since it does not consider the ability of a business to pay back the principal associated with a loan - only the interest expense. This is a significant flaw when a borrower is obligated to pay back a large amount of debt, and especially when this must be done in the near future. Thus, the interest coverage ratio is most applicable only to a short-term analysis of the financial performance of a borrower.