Coverage Ratio

What is a Coverage Ratio?

The coverage ratio is an indicator of a company’s financial health. It is a way to determine whether a company can fulfill its financial obligations without being short on cash flows or bankrupt. 

A higher ratio depicts that the company is in a stronger position to pay its debt component of total capital employed. 

These ratios are a form of financial ratios that direct toward the long-term financial health of a company. Third-party lenders and creditors consider these numbers before extending a loan to the concerned firm. 

There are many types of ratios that are used to inspect the financial soundness of a company. The ones that the lending parties or the creditors use are based on their respective requirements. 

For instance, if a company needs a loan of $1 million from a bank, the bank would only be interested in the DSCR (Debt Service Coverage Ratio) and interest coverage ratio. We will talk in detail about the frequently used ratios in the real world.

Thus, coverage ratios appear in many forms that can be molded and applied, conforming to the situation’s demands. 

Expanding the statement above, it means that a company or an organization can change the constituents of the ratio to use according to the purpose demands. 

They could also be crucial in determining a company's future standing present. They help to dive deeper into the intricacies of an organization's financial statements. 

As examining and constructing an understanding of the company is still a going concern, one should delve into the short-term fund availability of the company. For the same, one should calculate the company's short-term liquidity by looking at the liquidity and solvency ratios.

Types of coverage ratios

These ratios are also useful in comparing companies in the same industry or sector. Why the same industry or sector? For example, comparing a service company with a manufacturing company would be insignificant as there is no common basis to compare them.

As mentioned earlier, various ratios are useful in different situations and are calculated by lenders and creditors according to their needs. 

A ratio gauges a company's capacity to make on-time debt payments. Creditors and lenders frequently use these ratios for their current and new clients seeking credit.

Some of the most used ratios are:

• Interest Service Ratio
• Debt Service Coverage Ratios (DSCR)
• Asset Coverage Ratio
•  Cash Flow Coverage Ratio (CFCR)

Analysts commonly calculate the following ratios to understand the company's financial standing better. Please note that each ratio is unique in itself and that the ratio is calculated according to the borrower's debt-paying ability.  

Interest Service Ratio (iSCR)

The Interest Service Coverage Ratio (ISCR), also called the “Times Interest Earned,” is a measure to calculate the capacity of a borrower to pay its interest obligation. 

ISCR is a very important tool for lenders and financial institutions, like Banks, to acknowledge the ability to repay interest on loans by the borrower organization.

The formula to calculate the ISCR is given below: 

ISCR = EBIT/ Interest Expense 

Even though you will see people mentioning a particular “benchmark ratio” that an organization must have to avail of the loan, it differs from company to company to a large extent. To explain this in detail, let’s take an example. 

For instance, let’s say a company ABC Ltd. plans on launching a new product. This will require them to invest a large chunk of funds into their R&D operations for product development. They reach out to a bank seeking a loan of $2 million. 

As an obligation by the law, the bank will ask the firm to share its financial statements and an annual report containing all the transactions and their explanations.

For example, if the number obtained by the Interest coverage ratio is very high, one will immediately get impressed by just looking at the digits. At the same time, an expert would look into the story that the numbers entail.

Companies can also use this to hide their true conditions, which is always better for an expert to look and read into that company's books.  

The ratio may be high due to its lower COGS and operating expenses in that year (because EBIT= Revenue - (COGS + operating expenses)). Further, if the COGS is low, that indicates the inability of the firm to comply with its sales target. 

Thus, one should look into the intricacies of the ratios calculated as a single ratio can never define a company's financial health. 

Interest Service Ratio Example

Example: 

• Revenue = $50,000
• COGS = $35,000
• Interest Expense = $20,000

ISCR = $(50,000 - 35,000)/ $20,000 = 0.75 

Therefore, this company can cover its interest payment three times its revenue. 

Debt Service Ratio (DSCR)

Like the Interest service ratio, the Debt Service Coverage Ratio (DSCR) measures a firm’s capability to pay the entire amount of debt, that is, interest and principal amount. 

The formula to calculate the DSCR is as follows:

DSCR = Net Operating Income/ Total Debt Service

OR

DSCR = PAT + Interest + Non-cash Expenses/ Interest + Principal 

The ratio is calculated by the lending party, a bank/ financial institution, which helps to ascertain the financial standing of the company or the firm. 

As was said earlier, numbers should never be judged as they are, and their background and purpose must be looked into thoroughly. The ratio calculation is considered incomplete until the interpretation of the ratio is incorrect. 

Debt Service Ratio Example

Let's see the example below: 

A company’s financial statement yields the following numbers:

• Operating Income = $400,000
• Interest Payment = $10,000
• Principal Payment = $20,000

DSCR = $400,000/ ($10,000 + $20,000) = 13.33 (approx.)

Therefore, the company can cover its total debt obligation 13 times over its Net Operating Income. 

Asset Coverage Ratio (ACR)

This ratio is a measure to determine a firm's ability to repay the debt by selling its assets. In other words, it measures the current worth of the assets owned by a company.  

This ratio varies from industry to industry. Thus, a company from the Steel industry and a company from the Services industry must not be compared as their business models are completely distinct. 

The formula for Asset Coverage Ratio (ACR) is given below:

ACR= ((Total assets - Intangible assets) - (Current liabilities - Short-term debt))/ Total debt obligations

This ratio clearly shows an organization's assets against its debt obligations. It is important that the creditors or any other lenders are aware of this ratio so that in case of any default, they can recover their amount through their assets. 

A company must not default on its debt payment obligations. If it does, it will destroy the goodwill and creditworthiness of the company. Further, the lenders may impose a lawsuit against its inability to pay them back. 

Even if a company defaults on its obligation to pay, the borrower organization can sell off its assets to repay the amount. Thus, a company with a good asset ACR is essential for the stakeholders. 

Although an important measure for lenders and investors, the ACR may not show the company's true colors. One must know how to read between the lines. 

What does this mean to the lender? Let us consider a company ABC Ltd. with a decent ACR this year. Suppose the company buys many assets on loan in the next year. What change would you notice in the ACR of ABC Ltd.? 

You guessed it correctly! The ACR figure will inflate, portraying a deceptive picture of the company. Lenders who are careful enough to look into the figures of this ratio will be alert about the company’s huge loans to acquire those same assets. 

Cash flow coverage ratio (CFCR)

The cash flow coverage ratio (CFCR) compares a firm's operating cash flows to its interest obligations. It indicates whether a company can fulfill its debt obligations, knowing that it can efficiently cover its current liabilities and day-to-day expenses.

As per the internal users of this ratio, it helps them to analyze their standing and whether they are in a healthy position concerning funds availability. 

The formula to calculate CFCR is:

Short-term debt coverage ratio = (EBIT+Non-cash expenses) / Interest expense

A higher ratio indicates that the firm is in a good position to cover its current expenses and pay off its debt obligation along with the interest payments. However one must remember that an unusually higher ratio needs to be assessed carefully. 

Cash Flow Coverage Ratio (CFCR) Example

Let us take an example of a company with the following financial values:

• Loan Principal = $100,000
• EBIT = $400,000,
• Depreciation = $50,000
• Interest Obligation = $10,000
• Interest rate = 10%  

CFCR of this company = ($400,000 + $50,000)/ $10,000 

CFCR  = 45:1

The ratio seems too high as it indicates that the earnings of the firm overlap the interest obligation 45 times which seems to be an attractive ratio. However, an analyst must watch the figures with utter carefulness.

The CFCR thus helps one understand a firm's ability to pay off its debt, be it long-term or short-term. It gives investors, creditors, or lenders an insight into the company’s financial well-being. 

It reveals how efficiently the company utilizes its resources and generates sufficient operating cash flows. It should be noted that the cash flows generated by a company are of utter importance. 

It does not matter how much profit a company earns unless it has ample cash flows to fund its short-term obligations like inventory, bank overdraft, and dividends and to keep an adequate amount of retained earnings for future provision. 

Conclusion

There are more coverage ratios than those explained above. The formulae and the components constituting these ratios change from time to time and from user to user. Every ratio has its own uniqueness and usage.

These ratios play a pivotal role in the rating procedure too.

For example, the ICR plays a very important part in a company's credit rating. A rating reflects a firm’s ability to pay its debt obligation. This directly points out the financial health of the company. 

Suppose the ICR is slightly lower than what is required. In that case, the credit rating drops, making it tough for the company to seek funds through banks and other financial institutions. 

The higher the ratio, the more likely it is for the company to meet its daily expenses and debt obligations. This largely depends not only on the company's profitability but also on the sources and cost of borrowings.

Thus, it is of top priority that an investor or a creditor dwells into the intricacies of the numbers portrayed by a company and takes the step further as required.

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