An Introduction to Coverage Ratios



The ability to separate a company with a healthy amount of debt from an overgrown company is one of the most important skills investors can develop. Most companies use debt to help finance their businesses, whether they buy new equipment or hire additional workers. But if you rely too much on borrowing, you will catch up with any business. For example, if a company has difficulty paying its creditors on time, it may have to sell its assets, which is a competitive disadvantage. In extreme cases, you may have to file for bankruptcy.

Coverage rates are a convenient way to measure these risks. These relatively simple formulas may determine a company’s ability to repay existing debt and save investors from future heartaches.

The most widely used coverage rates include interest, debt repayment, and asset coverage.

Interest coverage ratio

The basic concept behind interest coverage ratio is very simple. The more profit a company makes, the more capable it is to repay interest. To reach this figure, simply divide Earnings before Interest and Tax (EBIT) by the interest expense of the company over the same period.

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Interest coverage ratio


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EBIT




Interest expense





text {interest coverage ratio} = frac { text {EBIT}} { text {Interest Expense}}



Interest coverage ratio = =Interest expenseEBIT....

..A ratio of 2 means that the company has twice as much income as it would have to pay interest. As a general rule, investors should be committed to companies with an interest coverage ratio (also known as “interested interest ratio”) of 1.5 or higher. Low percentages usually indicate companies struggling to repay bondholders, preferred stockholders and other creditors.

Principal and interest repayment coverage rate

Interest coverage ratio is widely used, but it has important drawbacks. In addition to interest expense, a company typically needs to repay a portion of its principal on a quarterly basis.

The principal and interest repayment coverage takes this into account. Here, the investor divides the net income by the total borrowing cost, that is, the principal repayment and the interest cost.

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net income




Principal repayment



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begin {aligned} & DSCR = frac { text {Net Income}} { text {Principal Repayments} + text {Interest Expense}} \ & textbf {where:} \ & DSCR = text {Debt repayment coverage} end {aligned}



..NSNSNSNS= =Principal repayment + Interest expensenet income..where:....

Numbers less than 1 mean that your business has negative cash flow. In reality, you pay more for borrowing than you bring through revenue. Therefore, investors should look for companies with at least one, preferably slightly higher debt repayment coverage, to ensure adequate levels of cash flow to address future debt.

Illustration: To see the potential difference between these two coverage rates, take a look at the fictional company Cedar Valley Brewing. The company generates a quarterly profit of $ 200,000 (EBIT is $ 300,000) and pays $ 50,000 in interest accordingly. Interest coverage ratio looks very good because Cedar Valley borrowed a lot during the low interest rate period.

..



Interest coverage ratio


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6



text {interest coverage ratio} = frac {300,000} {50,000} = 6



Interest coverage ratio= =Five0,000300,000..= =6..

However, the principal and interest repayment coverage rate reflects a significant principal amount of $ 140,000 that the company pays quarterly. The resulting 1.05 number leaves little room for error if the company’s sales are hit unexpectedly.

..



Principal and interest repayment coverage rate


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2


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Five



text {Debt-Service Coverage Ratio} = frac {200,000} {190,000} = 1.05



Principal and interest repayment coverage rate= =190,000200,000..= =1..0Five..

The company generates positive cash flow, but when debt repayment coverage is taken into account, it is risky from a debt perspective.

Asset coverage

The ratios mentioned above compare a company’s debt in relation to revenue. Therefore, it is a good way to look at an organization’s ability to cover today’s debt. However, if you want to predict the long-term profit potential of a company, you need to carefully consider your balance sheet. In general, the more assets your company holds compared to your total debt, the more likely you are to make future payments.

Asset coverage is based on this idea. Basically, we take into account fixed liabilities, acquire the company’s tangible assets, and divide the remaining number by the outstanding liabilities.

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Total assets
















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Short-term debt








begin {aligned} & ACR = frac {(TA – IA) – (CL – STDO)} {TDO} \ & textbf {where:} \ & ACR = text {Asset coverage} \ & TA = text {Total assets} \ & IA = text {Intangible assets} \ & CL = text {Current liabilities} \ & STDO = text { Short-term debt} \ & TDO = text {total outstanding debt} end {aligned}



..NSNSNS = = NSNSO(((NSNS MeNS) (((NSL NSNSNSO)..where:NSNSNS = = Asset coverageNSNS = = Total assetsMeNS = = Intangible assetsNSL = = Current LiabilitiesNSNSNSO = = Short-term debt....

Whether the resulting numbers are acceptable depends on the industry. For example, utilities typically need an asset coverage of 1.5 or higher, but the traditional threshold for industrial companies is 2.

Illustration: This time, JXT Corp, which manufactures factory automation equipment. Let’s look at. The company has $ 3.6 million in intangible assets, including $ 300,000 in trademarks and patents. We also have $ 600,000 in current liabilities, including short-term debt of $ 400,000. The company’s total debt is equivalent to $ 2.3 million.

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ACR



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text {ACR} = frac {(3,600,000 – 300,000) – (600,000-400,000)} {2,300,000} = 1.3



ACR = = 2,300,000(((3,600,000 300,000) (((600,000Four00,000)..= =1..3..

At 1.3, the percentage of companies is well below the normal threshold. This in itself indicates that JXT does not have enough assets to take advantage of its considerable debt.

One limitation of this formula is that it depends on the book value of a company’s assets. This is often different from the actual market value. For the most reliable results, it is usually helpful to evaluate your enterprise using multiple metrics rather than relying on a single ratio.

Business evaluation

Investors can use coverage in one of two ways. First, you can track changes in your company’s debt situation over time. If the principal and interest repayment coverage is barely acceptable, it’s a good idea to look at the company’s recent history. If the ratio is declining gradually, it may be only a matter of time before it falls below the recommended value.

Coverage rates are also valuable when looking at a company in relation to that company …


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