Coverage Ratio
Candlefocus EditorA coverage ratio can be defined as a measure derived from the income and expenses of a business to assess its financial health. It is important to be aware of the different types of ratios available.
The most common coverage ratios are:
1. Interest Coverage Ratio: This ratio is used to measure how easily a company can pay its debt obligations, based on the amount of earnings it has available. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense. A higher ratio, such as 4:1 or higher, is considered a sign of financial health, because it indicates the company can easily pay off its debt.
2. Debt Service Coverage Ratio: This ratio measures a company's ability to meet its required debt payments. It is calculated by dividing a company’s net operating income by its debt service. A higher ratio is desirable, since it indicates the company has enough operating income to meet its debt payments.
3. Asset Coverage Ratio: This ratio looks at a company's ability to meet its financial obligations by comparing the value of its assets to its debt. It is calculated by dividing a company’s total assets - including cash, investments, and receivables. - by its total debt. This ratio acts as a measure of financial integrity, since it shows how secure a company’s assets are in relation to its debt.
Overall, coverage ratios are an important tool used to measure a company’s financial health, and investors should use them to identify potential risks and to determine how a company may perform in the future. Companies with strong coverage ratios are better able to meet their financial obligations, which is why they are important for investors to keep track of.