What is the Coverage Ratio?
Coverage ratio represents a company’s ability to service its debt and meet its financial obligations such as interests payments or dividends. The higher it is, the easier it should be to make interest payments on its debt or pay dividends. The trend of coverage ratios over time is also studied by analysts and investors to ascertain the change in a company’s financial position.
In any financial market, it is a measure of a company’s ability to service its debt and meet its financial obligations. The higher the coverage ratio, the easier it should be to make interest payments on its debt or pay dividends.
Explaining Coverage Ratio
These are come in several forms and can be used to help identify companies in a potentially troubled financial situation, though low ratios are not necessarily an indication that a company is in financial difficulty. Many factors go into determining these ratios and a deeper dive into a company’s financial statements is often recommended to ascertain a business’s health.
Net income, interest expense, debt outstanding, and total assets are just a few examples of the financial statement items that should be examined. To ascertain whether the company is still a going concern, one should look at liquidity and solvency ratios, which assess a company’s ability to pay the short-term debt (i.e., convert assets into cash).
Investors can use these ratios in one of two ways. First, you can track changes in the company’s debt situation over time. In cases where the debt-service ratio is barely within the acceptable range, it may be a good idea to look at the company’s recent history. If the ratio has been gradually declining, it may only be a matter of time before it falls below the recommended figure.
Coverage ratios are also valuable when looking at a company in relation to its competitors. Evaluating similar businesses is imperative, because an interest coverage ratio that’s acceptable in one industry may be considered risky in another field. If the business you’re evaluating seems out of step with major competitors, it’s often a red flag.
While comparing these ratios of companies in the same industry or sector can provide valuable insights into their relative financial positions, doing so across companies in different sectors is not as useful, since it might be like to comparing apples and oranges. Common ratios include the interest coverage ratio, debt service coverage ratio, and asset coverage ratio. These are summarized below.
Types of Coverage Ratios
Interest Coverage Ratio
This ratio measures the ability of a company to pay the interest expense on its debt. The ratio, also known as the times interest earned ratio, is defined as:
ICR = EBIT / Interest Expensewhere:
EBIT=Earnings before interest and taxes
An interest coverage ratio of two or higher is generally considered satisfactory.
Debt Service Coverage Ratio
The debt service coverage ratio (DSCR) measures how well a company is able to pay its entire debt service. Debt service includes all principal and interest payments due to be made in the near term. The ratio is defined as:
DSCR= Net Operating Income / Total Debt Service
A ratio of one or above is indicative that a company generates sufficient earnings to completely cover its debt obligations.
Asset Coverage Ratio
This ratio is similar in nature to the debt service ratio but looks at balance sheet assets instead of comparing income to debt levels. The ratio is defined as:
ACR = Total Assets−Short-term Liabilities / Total Debt
Total Assets=Tangibles, such as land, buildings, machinery, and inventory
As a rule of thumb, utilities should have an ACR of at least 1.5, and industrial companies should have an ACR of at least 2.
The Unilever Annual Report claims as below:
“We continue to maintain our leverage by targeting a Net Debt to underlying EBITDA ratio of 2x, consistent with a credit rating of at least A/A2. During 2018, we returned €6 billion to shareholders through our share buyback program following the sale of spreads.“