Definition, Types, Formulas, and Examples

What Is a Coverage Ratio?

A coverage ratio reflects whether or not a company will be able to service its debt and meet other financial obligations, including pay dividends.

A high coverage ratio indicates that it’s likely the company will meet its future interest payments and meet all its financial obligations.

Analysts and investors may study any changes in a company’s coverage ratio over time to assess the company’s financial position.

Understanding Coverage Ratios

Investors can use coverage ratios in different ways. A coverage ratio can be used to help identify companies in a potentially troubled financial situation.

While a high coverage ratio is one indication that a company is likely to meet all its financial obligations, a low ratio does not always indicate that a company is experiencing financial difficulty.

(A deeper dive into a company’s financial statements is often recommended to get a better sense of a business’ health.)

Coverage ratios are also valuable when comparing one company to its competitors. Evaluating the coverage ratios of companies in the same industry or sector can provide useful insights into their relative financial positions.

However, it’s imperative that you only evaluate similar businesses; a coverage ratio that’s acceptable in one industry may be considered risky in another field.

Types of Coverage Ratios

There are different types of coverage ratios. Common coverage ratios include the interest coverage ratio, debt service coverage ratio, and asset coverage ratio.

Interest Coverage Ratio

The interest coverage ratio measures the ability of a company to pay the interest expenses on its debt. The interest coverage ratio—also called the times interest earned (TIE) ratio—is defined as:

Interest Coverage Ratio = EBIT / Interest Expense

Where:

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

The asset coverage ratio is similar in nature to the debt service coverage ratio, but it looks at balance sheet assets (instead of comparing income to debt levels). The ratio is defined as:

Asset Coverage Ratio = Total Assets – Short-Term Liabilities / Total Debt

Where:

Total Assets = Tangibles (such as land, buildings, machinery, and inventory)

As a rule of thumb, utilities should have an asset coverage ratio of at least 1.5, and industrial companies should have an asset coverage ratio of at least two.

Other Coverage Ratios

Several other coverage ratios are also used by analysts, although they are not as common as those detailed above.

• The fixed-charge coverage ratio measures a firm’s ability to cover its fixed charges, such as debt payments, interest expense, and equipment lease expense. It shows how well a company’s earnings can cover its fixed expenses. Banks often look at this ratio when evaluating whether to lend money to a business.
• The loan life coverage ratio (LLCR) is used to estimate the solvency of a firm—or the ability of a borrowing company to repay an outstanding loan. The LLCR is calculated by dividing the net present value (NPV) of the money available for debt repayment by the amount of outstanding debt. 
• The EBITDA-to-interest coverage ratio is used to assess a company’s financial durability by examining whether it is profitable enough to pay off its interest expenses.
• The preferred dividend coverage ratio measures a company’s ability to pay off its required, preferred dividend payments. Preferred dividend payments are the scheduled dividend payments that are required to be paid on the company’s preferred stock shares. Unlike common stock shares, the dividend payments for preferred stock are set in advance. They cannot be changed from quarter to quarter; the company is required to pay them.
• The liquidity coverage ratio (LCR) refers to the proportion of highly liquid assets held by financial institutions to ensure their ongoing ability to meet short-term obligations. This ratio is essentially a generic stress test; it is analyzed to anticipate market-wide shocks and make sure that financial institutions possess suitable capital preservation to ride out any short-term liquidity disruptions that may impact the market.
• The capital loss coverage ratio is the difference between an asset’s book value and the amount received from a sale relative to the value of the nonperforming assets being liquidated. The capital loss coverage ratio is an expression of how much transaction assistance is provided by a regulatory body in order for an outside investor to take part.

Examples of Coverage Ratios

To see the potential difference between coverage ratios, let’s look at a fictional company, Cedar Valley Brewing.

The company generates a quarterly profit of $200,000 (EBIT is $300,000), and interest payments on its debt are $50,000.

Interest Coverage Ratio

Because Cedar Valley did much of its borrowing during a period of low interest rates, its interest coverage ratio looks extremely favorable:

$\begin{aligned} &\text{Interest Coverage Ratio} = \frac{ \$300,000 }{ \$50,000 } = 6.0 \\ \end{aligned}$​Interest Coverage Ratio=$50,000$300,000​=6.0​

Debt-Service Coverage Ratio

The debt-service coverage ratio, however, reflects a significant principal amount the company pays each quarter: a total of $140,000 ($190,000 – $50,000 in interest). The resulting figure of 1.05 leaves little room for error if the company’s sales take an unexpected hit:

$\begin{aligned} &\text{DSCR} = \frac{ \$200,000 }{ \$190,000 } = 1.05 \\ \end{aligned}$​DSCR=$190,000$200,000​=1.05​

Even though the company is generating a positive cash flow, it looks riskier from a debt perspective once debt-service coverage is taken into account.

The Bottom Line

The coverage ratio evaluates how capable a company is at paying its debts with its current income. Lenders, investors, and creditors use the coverage ratio to gain insight into a company’s financial situation and determine its riskiness for future borrowing.

A good coverage ratio indicates that it’s likely the company will be able to make all its future interest payments and meet all its financial obligations. The actual figure that constitutes a good coverage ratio varies from industry to industry.