Question

What is a coverage ratio? Give an example. How is it used?

Answer 1

Coverage ratio measures the ability of a company to meet its debt obligations such as paying interest or interest and principal payments in a timely manner.

Example 1:

If EBIT = $100 million and Interest expenses = $40 million, then

This indicates that the company can make 2.5 times the inerest expenses with its operating profit (EBIT), which is good. Interest coverage ratio of less than one is not good as it indicates the company is not generating enough operating profits to pay for interest expenses.

Example 2:

This measures the ability of the company to service its entire debt (Not just interest expenses).

Again, a ratio of > 1 is good, while < 1 is bad.

Coverage ratios are used by banks before making a loan to a company. Higher the coverage ratio the better it is because it indicates the company can fulfill the debt obligations with its operating cash flows.