Coverage ratio

A coverage ratio measures the ability of a business to pay its debts in a timely manner. Coverage ratios are commonly employed by creditors and lenders, both for their existing customers and new customers applying for credit. The ratios may be used internally, though usually only when loan covenants require that a business must maintain a certain minimum ratio or else face a loan default.

A coverage ratio could provide a narrow focus on just the ability to pay back interest on a loan (the interest coverage ratio) or examine the ability to pay back both the interest and scheduled principal payments on a loan (the debt service coverage ratio). The latter type of measurement is preferable, since it provides the most detailed analysis of whether a business can fulfill its debt obligations.

There is no particular coverage multiple that is specifically considered good or bad. In general, the higher the ratio, the better the probability that a company will be able to pay its debts. If a ratio is less than 1:1, this is a strong indicator of impending payment problems. The best way to examine a coverage ratio is to plot it on a trend line over a long period of time; if the trend is declining, this can be an indicator of future problems, even if the ratio is currently high enough to indicate a reasonable level of liquidity.

Coverage ratios should be evaluated in concert with the volatility of company cash flows. If cash flows fluctuate a great deal over time, even a high coverage ratio may not provide an adequate indication of the ability to pay. Conversely, if company cash flows are extremely steady and reliable, a much lower coverage ratio might still provide a creditor or lender with some confidence concerning repayment.

Related Courses

Business Ratios Guidebook 
The Interpretation of Financial Statements