Coverage ratios

Coverage ratios are a mathematical way to find out how able a company is to pay off its liabilities. On paper, coverage, liquidity and solvency ratios might look the same, but they are clearly different. Coverage ratios helps measuring a company’s ability to clear off its debt and other obligations.

Simply put, these ratios measure how easily companies can afford to make the interest payments related to their debt. Some ratios also facilitate calcualtions of obligations that are not typical liabilities like regular dividend payments to stockholders.

The major coverage ratios used to judge a companies are:

Times Interest Earned Ratio

The times interest earned ratio aslo known as interest coverage ratio helps measuring the proportionate amount of income that can be utilised to cover interest expenses in the future.

It also helps to determine a firm’s ability to pay off its debts and interests, this is the reason why it is also considered as solvency ratio at times. Since these interests are paid on a long-term basis, they are often considered as an ongoing, fixed expense. In most cases, if the company can’t pay off its ongoing fixed expenses, it could go bankrupt and cease to exist. Therefore, this ratio could be considered a solvency ratio.

The formula to calculate Times Interest Earned Ratio is:

Times Interest Earned Ratio = Income before Interest and Taxes or EBIT/Inetrest Expense

Fixed Charge Coverage Ratio

The fixed charge coverage ratio is a financial ratio that determines how capable a firm is to pay all of its fixed charges or expenses with its income before interest and income taxes. The fixed charge coverage ratio can be seen as an extended version of the times interest earned ratio.

The fixed charge coverage ratio can be used flexibly with almost any fixed cost since fixed costs like lease payments, insurance payments, and preferred dividend payments can be built into the calculation.

The formula to calculate Fixed Charge Coverage Ratio is:

Fixed Charge Coverage Ratio = EBIT + Fixed charges before taxes/Fixed charges before taxes + Interest

Debt Service Coverage Ratio – DSCR

The debt service coverage ratio is a financial ratio that calculates a company’s ability to serve its current debts by putting its net operating income and total debt service obligations into comparison. Simply put, this ratio compares the cash available with a company with its current interest, principle, and sinking fund obligations.

Both creditors and investors remian very much concerned aout debt service coverage ratio, but creditors most often analyze it because this ratio calculates a firm’s ability to pay off its current debt obligations, current and future creditors.

The forula to calculate debt service coverage ratio is:

Debt Service Coverage Ratio = Operating Income/ Total Debt Service Costs