One of the most common forms of fundamental analysis is the use of ratios. Ratios give investors a snapshot of a company’s financial health as it relates to particular metrics before they dive deeply into financial statements. Some ratios, like a company’s price-earnings (P/E) ratio, are a way to determine a company’s valuation. Other ratios, such as the quick ratio, are used to measure a company’s ability to pay off short-term debt.
Individuals and businesses both understand the importance of maintaining a healthy debt to income ratio. If you are applying for a home loan, a bank will want to know that you have sufficient income to make the payment required and still meet your other obligations. And, in the best case scenario, they will want to ensure that you have sufficient remaining cash flow to be more than just living from paycheck to paycheck in order to pay the mortgage.
It’s the same way with a business. Investors and analysts understand that a business needs to take on debt and that it can be a good thing. However, if a business becomes overly leveraged, it can quickly run into serious financial problems. One of the ways investors can get a snapshot of how well a company can service its existing debt obligations is by looking at their coverage ratio.
This article will define the coverage ratio, the different kinds of coverage ratios and how they are calculated. We’ll also briefly describe the other forms of ratio analysis that investors may use in addition to coverage ratios.
What is the coverage ratio?
The coverage ratio is actually a series of ratios that are used by investors to determine a company’s ability to meet their financial obligations. A higher number (i.e. the farther the ratio is above 1, the easier it should be for a company to service its debt and pay dividends. A coverage ratio can change over time so investors need to look at how the company ratio has changed over time to see what it says about a company’s financial position.
A coverage ratio is one data point for investors to consider when assessing a company’s financial position. If a business has a low number, it may not be a sign of long-term financial problems. Therefore it’s important that investors perform other forms of ratio analysis. Some of those will be discussed later in this article.
Coverage ratios can be very helpful when comparing one company to another in the same sector because a wide discrepancy between one company’s coverage ratio and another may speak to their competitive position. However, investors need to be cautious that they do not put too much stock at looking at coverage ratios across sectors because disparate sectors will have different business models.
What are different types of coverage ratios?
There are three primary coverage ratios used by analysts and investors. Each approach views the issue of how efficiently a company can meet its obligations from a slightly different lens.
- Interest Coverage Ratio– This is also known as the Times Interest Earned or (TIE) Ratio. This ratio measures a company’s ability to pay the interest expense on the debt they are carrying. Since a company has two options for financing its long-term projects: debt and equity. Their decision to use one over the other will affect their long-term capitalization and so companies will look at how different alternatives will alter their interest coverage ratio to determine what may be the most sustainable way to service their debt. In general, investors are looking for a ratio of 2 or higher.
The calculation for the Interest Coverage Ratio is:
Earnings Before Interest and Taxes (EBIT) / Total Annual Interest Expense
Example:
Company ABC has $8 million of debt obligations and they are currently paying an interest rate of 5%. They also have the outstanding stock valued at $8 million. They need to raise more capital and the cost of issuing new shares is an interest rate of 6%. They decide to issue new shares. To calculate their Interest Coverage Ratio, they would add the percentage cost of their debt as follows:
(5% x 8 million) + (6% x 8 million) or $880,000.
If the company’s EBIT is $2.5 million, their Interest Coverage Ratio would be:
2,500,000/880,000 = 2.84. This would mean that the company’s TIE is almost three times their annual interest expense.
- Debt Service Coverage Ratio(DSCR)– this ratio is a comparison of a company’s cash flow with their entire debt load (defined as principal and interest payments that need to be paid in the near term - usually defined as 12 months). The calculation is:
Net Operating Income (in many cases this number will include their EBITDA (Earnings Before Interest Payments, Taxes, Depreciation and Amortization/Total Debt Service
Investors and lenders use this formula to determine if a company is generating enough earnings to comfortably cover the principal and interest payments on its debt. They are looking for a number that is greater than 1. This is because, in addition to not wanting to see you default, lenders want to ensure you are not going to just be "getting by" without sufficient cash flow to grow your business. Businesses that do not have enough money or just enough money to cover their debt payments, would not be seen as doing well enough to be approved for a loan.
Example:
If a company has a Net Operating Income of $200,000 and they have a $200,000 loan with an interest rate of 20% for two years. Their annual debt payment (including interest) is 122,148. Their DSCM would be:
200,000/122,148 = 1.63
This means that the company is generating approximately 60% more cash flow than they should need to make their debt payments on a yearly basis.
- Asset Coverage Ratio– This ratio is closely related to the DSCM, but bases its calculation on the tangible assets shown on a company’s balance sheet. The formula for this ratio is:
(Total Tangible Assets – Short-Term Liabilities)/Total Debt Outstanding
All of these components can be found on a company’s balance sheet.
The Asset Coverage Ratio is perhaps the most theoretical of all the coverage ratios. This is because the question it is really asking is how well a company can repay its debt obligations by selling its assets. Why is this important? If a company gets into financial difficulty it is not obligated to repay shareholders. They can suspend dividend payments. But if they have other debt, in the form of loans etc., they are under an obligation to pay their creditors. If the business gets to the point where they have to liquidate, they may have to sell assets.
With this in mind, the Asset Coverage Ratio gives investors the sense of a company's ability to turn assets into cash. The push and pull that goes on here is that investors want to see a high Asset Coverage Ratio because it indicates a company whose assets outweigh their liabilities. On the other hand, a company may put more importance on maximizing the amount of money it can borrow, which could put it at odds with maintaining a healthy asset coverage ratio.
One of the common strategies for interpreting a company’s Asset Coverage Ratio is to compare a company’s ratio over multiple years.
Example:
|
Asset Coverage Ratio
|
Year 1
|
Year 2
|
Year 3 (most recent)
|
|
Company A
|
1.07
|
1.15
|
1.26
|
|
Company B
|
1.31
|
1.28
|
1.20
|
In both cases, the Asset Coverage Ratio has been above 1 which is considered good. However, a closer look shows that while Company A's ratio is increasing over time; Company B's ratio is declining, which is usually an indicator that the company is taking on more debt. Does this mean that Company A is a healthier company? Not necessarily. In this way, ratios offer a snapshot into a company’s performance. Analysts and investors need to look at a company’s balance sheet, listen to conference calls, and study earnings reports for a better understanding of the business conditions that may be causing the ratio to change.
Coverage ratio is one group of ratio analysis
In addition to a company’s coverage ratio, the most common ratio groups are:
Liquidity ratios– A measurement of a company’s ability to pay off their short-term debts as they come due using only the company’s current (or quick) assets. Liquidity is the ability of a company to convert its assets into cash without affecting the asset price. Investors use liquidity ratios to get a sense of how quickly a company can generate cash to service short-term debt that is coming due. Some examples of liquidity ratios are the currency ratio, working capital ratio, and quick ratio.
Solvency ratios– A measurement of a company’s long-term viability in relation to their total assets, equity and earnings. Whereas liquidity ratios focus on a company’s ability to pay their short-term debt, solvency ratios are looking at a company’s ability to remain solvent because they have the resources to pay their long-term debt, including the interest on that debt. Some examples of solvency ratios are debt-equity ratio, debt-assets ratio, and interest-coverage ratio.
Profitability ratios– A measurement of a company’s efficiency at generating profit from its operations. This ratio is useful because if a company is using all their available revenue to service debt, they won’t be making the profit that will allow them to reward shareholders. Some common profitability ratios are profit marking, return on equity, return on assets, return on capital employed, and gross margin ratio.
Efficiency ratios– A measurement of how well a company uses its assets and liabilities to generate sales and maximize profits. This ratio can give investors a closer snapshot of the inner workings of a company’s business. Common efficiency ratios are asset turnover ratio, inventory turnover, and days’ sales in inventory.
Market prospect ratios– A measurement of what investors can expect to receive in earnings from their investments, which can be predictive of future price movement in a stock. These are among the most well-known and commonly used ratios such as dividend yield, P/E ratio, and earnings per share. Because they are so common they are usually included in any stock quote page.
The bottom line on coverage ratio
A healthy company relies on debt to finance its continuing growth. However, companies balance the need to take on more debt with their ability to service the debt. This includes having the ability to not only pay down the principal but to make the current interest payments. One way that investors can analyze a company's ability to repay their debt is by using coverage ratios.
There are three common coverage ratios. Each one looks at a company’s ability to service their debt in a different way.
- The Interest Coverage Ratio, which is also known as the Times Interest Earned (TIE) ratio. This measures the company’s to pay the interest on their short-term debt using their existing Earnings before Interest and Taxes (EBIT).
- The Debt Service Coverage Ratio (DSCR) measures a company’s cash flow against their entire debt load. This would be similar to an individual applying for a mortgage.
- The Asset Coverage Ratio is the most theoretical of the three coverage ratios as it measures a company’s ability to repay their creditors should they have to liquidate assets in case of financial difficulty.
In general, investors are looking for a number higher than 1 for all of these ratios. However, a company's coverage ratio is a snapshot of what is going on with a company. It's helpful to look at the coverage ratios over a period of earnings periods or even years. When comparing two companies, it's important that you look at companies in the same sector as the capital requirements between two sectors may vary greatly.
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