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A coverage ratio is designed to determine a company's ability to pay off one of its financial obligations in terms of the cash flow it produces. There are several different ratios available, including ones concerning interest, fixed charges, and overall debt — all designed to measure a company's short-term strength. In general, a coverage ratio is calculated by taking a company's earnings and dividing that number by the specific expense in question. If the ratio is higher than 1, it means that the company can pay off the expense with its profits and have money left over, while a number lower than 1 indicates they don't have enough money to meet this financial demand.
When attempting to measure financial solvency, a coverage ratio is an accurate indicator of how well a company is doing, at least in the short-term. Very simply, these ratios measure whether a company can pay its bills. The inability to do that likely means that the company is struggling and could possibly be heading for a collapse. Solid coverage ratios generally indicate financial strength.
The interest coverage ratio, also known as times interest earned, is arrived at by taking a company's earnings before interest and taxes and dividing it by the amount of interest the company owes to creditors. For example, imagine that a company has earned $5,000 US Dollars (USD) in a specific time period and owes $4,000 USD in interest payments over that same period. The $5,000 USD is divided by $4,000 USD, which comes out to a times interest earned number of 1.25. This essentially means that the company can cover its interest payments and still have 25 percent of its original profits left over.
In a similar fashion, other ratios may be calculated. For example, the debt service ratio takes into account both interest and principal payments, while the fixed-charge ratio includes fixed charges on a company's books, such as leases. Any time that one of these ratios turns out to be lower than 1, then it's safe to say that the company is in danger of becoming insolvent.
Different industries have different standards for what constitutes a solid coverage ratio, depending on the volatility of the industry in question. It's best to compare businesses to others in the same industry to get a true picture of how their ratios hold up. One other caveat to note is that an extremely high ratio is not necessarily a positive statistic for a business. That could indicate that the company is eliminating their debt at too fast a pace, wasting money that could be used for other investments to grow the business.
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