Definition - What does Coverage Ratio mean?
Coverage ratio is the ability of an organization to meet its financial obligations and liabilities. In general, a higher coverage ratio denotes a greater ability of the organization to meet its creditors' obligations while a lower coverage ratio means less ability. This is why coverage ratio is widely used by creditors, shareholders, investors and any other stakeholders as a way to gauge the risk of an organization.
Divestopedia explains Coverage Ratio
The coverage ratio is the most basic of ratios used to assess the financial health of a company and its financial position with regard to its liabilities. From an investor's perspective, it is important to identify the companies with a healthy coverage ratio to make the most out of one's investment.
All companies have a mix of both debt and equity for its capital. A 100 percent debt model, though, would make it difficult to grow and expand as the company would always be hindered with interest payments. On the other hand, a 100 percent equity model also does not work for both private and public companies because the risk levels are too high for investors. For this reason, most companies follow a mix of both.
When a company is unable to repay its liabilities and is forced to sell its assets, then the possibility of bankruptcy increases. If a company files for bankruptcy, then investor returns are greatly diminished. Therefore, it is imperative for the investor to assess the risk aspect of the company as well as one's investment, which the coverage ratio helps with.
There are three different coverage ratios: interest, debt-service and asset. The interest coverage ratio determines if the company has enough assets and capabilities to meet its interest obligations while debt-service coverage ratio determines the ability to pay off debt. Finally, asset ratio determines the amount of available assets to cover the long-term obligations of the company.
Interest Coverage Ratio = EBIT / Interest Expense
Debt-service Coverage Ratio = Net Income / (Principal + Interest)
Asset Ratio = (Total Tangible Assets - Current Liabilities) / Total Debt
The coverage ratio is an important ratio to calculate when preparing a financial model as it determines the amount of debt capital available for a business acquisition.