By: Shaun From: www.myaccountingcourse.com
Coverage ratios are comparisons designed to measure a company’s ability to pay its liabilities. On the surface, coverage ratios might sound a lot like liquidity and solvency ratios, but there is a distinct difference. Coverage ratios analyze a company’s ability to service its debt and other obligations.
In other words, these ratios measure how well companies can afford to make the interest payments associated with their debt. Some ratios also include obligations that are not typical liabilities like regular dividend payments to stockholders.
Here are the main coverage ratios used to analyze companies.
Fixed Charge Coverage Ratio
The fixed charge coverage ratio is a financial ratio that measures a firm’s ability to pay all of its fixed charges or expenses with its income before interest and income taxes. The fixed charge coverage ratio is basically an expanded version of the times interest earned ratio or the times interest coverage ratio. The fixed charge coverage ratio is very adaptable for use with almost any fixed cost since fixed costs like lease payments, insurance payments, and preferred dividend payments can be built into the calculation.
The fixed charge coverage ratio shows investors and creditors a firm’s ability to make its fixed payments. Like the times interest ratio, this ratio is stated in numbers rather than percentages. The ratio measures how many times a firm can pay its fixed costs with its income before interest and taxes. In other words, it shows how many times greater the firm’s income is compared with its fixed costs. In a way, this ratio can be viewed as a solvency ratio because it shows how easily a company can pay its bills when they become due. Obviously, if a company can’t pay its lease or rent payments, it will not be in business for much longer. Higher fixed cost ratios indicate a healthier and less risky business to invest in or loan to. Lower ratios show creditors and investors that the company can barely meet its monthly bills.
Debt Service Coverage Ratio
The debt service coverage ratio is a financial ratio that measures a company’s ability to service its current debts by comparing its net operating income with its total debt service obligations. In other words, this ratio compares a company’s available cash with its current interest, principle, and sinking fund obligations. The debt service coverage ratio is important to both creditors and investors, but creditors most often analyze it. Since this ratio measures a firm’s ability to make its current debt obligations, current and future creditors are particularly interest in it. Creditors not only want to know the cash position and cash flow of a company, they also want to know how much debt it currently owes and the available cash to pay the current and future debt.
The debt service coverage ratio measures a firm’s ability to maintain its current debt levels. This is why a higher ratio is always more favorable than a lower ratio. A higher ratio indicates that there is more income available to pay for debt servicing. For example, if a company had a ratio of 1, that would mean that the company’s net operating profits equals its debt service obligations. In other words, the company generates just enough revenues to pay for its debt servicing. A ratio of less than one means that the company doesn’t generate enough operating profits to pay its debt service and must use some of its savings. Generally, companies with higher service ratios tend to have more cash and are better able to pay their debt obligations on time.
“Do you know your numbers? Knowing your numbers starts with knowing and understanding how the numbers are generated”.