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Financial Ratio: Know the Benefits of the Coverage Ratio

Written on February 13, 2019   By   in Business

Coverage Ratio (Coverage) is a Financial Ratio used to measure a company’s ability to pay its liabilities. At a glance, the Coverage Ratio might sound very similar to the Liquidity and Solvability Ratio. However, there are actually differences with these two ratios. Simply put, the Coverage Ratio analyzes the company’s ability to pay off debt and other forms of bonds.

More specifically, the Coverage Ratio measures how well the company is able to make interest payments related to their debt or bonds. Several types of ratios in the Coverage Ratio include components of bonds that are not included in the liability component. One form of the bonds is the payment of regular dividends to shareholders. The following are the types of ratios included in the Coverage Ratio used to analyze the company:

Interest Coverage Rate

The ratio of Times Interest Earned is also commonly called the Interest Coverage Ratio. The metric measures the amount of profit before tax and interest used to pay interest costs in the future.

Interest Coverage Ratio expressed in units of numbers and not by percentages. This number shows how many times a company can pay interest with profit before tax and interest. So, obviously the larger number of ratios is considered to be more profitable than the smaller ratio.

As an illustration, if the amount of Interest Coverage Ratio produces 4, it means that the company generates sufficient income to pay the total interest expense 4 times. In other words, the company’s income is 4 times higher than the interest cost in a period that is used as the basis for calculation.

Creditors will like the company with a higher Interest Coverage Ratio. Because this shows that the company is able to pay interest payments when due. A higher ratio also implies low credit risk. While the low ratio shows high credit risk.

The formulations of this ratio are:

Profit before Taxes and Interest ÷ Interest Fees

Fixed Cost Coverage Ratio

Fixed Cost Coverage Ratio is a financial ratio that measures a company’s ability to pay all its costs or fixed expenses with profit before tax and interest. Basically, the Fixed Cost Coverage Ratio is a development version of the interest coverage ratio. The fixed cost component included in calculating this ratio is like lease payments, insurance, preferred stock dividends, and others.

This type of ratio shows investors and creditors how well the company’s ability to pay its fixed costs. Similar to the Interest Coverage Ratio, this ratio is expressed in numbers and not percentages.

Coverage Ratio High fixed costs show a healthier and less risky business. This means that the company has more income to pay off its fixed costs. While a low ratio indicates that the company has not been able to cover its fixed costs. The age of the company that has a low or even minus Fixed Cost Coverage Ratio can be said to not last long. This is bad news for creditors and investors.

The formulations for this ratio are:

(Before Tax and Interest Profit + Fixed Cost before Tax) ÷ (Fixed Cost before Tax + Interest Fee)

Debt Service Coverage Ratio

Debt Coverage Ratio is a ratio that measures a company’s ability to pay current debt. Furthermore, this ratio shows the ability of the company to pay off the costs and principal of debt and smooth bonds with net operating income. In other words, this ratio compares cash from the company’s operational activities with interest costs and short-term Sinking Fund Obligation.

This ratio is specifically paid more attention by creditors than investors. Creditors don’t just want to know the amount and cash flow of a company. They also want to know how much current debt the company has and the cash available to pay the debt costs.

Unlike the Debt Ratio, Debt Coverage Ratios consider all costs associated with debt. This includes interest costs and other obligations such as pension obligations and reserve fund bonds. Therefore, this ratio is more able to show the company’s ability to pay its debt than the Debt Ratio.

For example, if the amount of the company’s Debt Coverage Ratio shows number 1, it means that the company’s net operating profit is equal to its debt obligations. In other words, the company generates enough income to pay for its current debt. If the number is less than one, the company does not have enough operating profit to pay its current debt and must use a portion of its savings.

Generally, companies with a higher Debt Coverage Ratio tend to have more cash and are better able to pay their current debt obligations in a timely manner.

The formulations for this ratio are:

Operating Income ÷ Total Debt Service Costs (Total Debt Service Costs)

Conclusion

Coverage Ratio is a Financial Ratio that can better explain how a company pays its obligations compared to Debt Ratio and Solvability. And so that management can consider the ratio, they certainly need financial statements. Today, Financial Reports can be generated quickly and automatically through the use of Accounting Software. One of the Accounting Software that can meet these needs is Journal.

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