Coverage ratios are accounting ratios that can help a small business analyze its ability to maintain operations, stay alive, and continue to grow. Learn more about three of the most important coverage ratios for a new small business.
What are Coverage Ratios?
Coverage ratios help determine if a company has a healthy amount of debt or if it is overextended. Coverage ratios analyze a company’s ability to service its debt and other financial obligations. They help show how well a company can afford to make its interest payments. Relying too heavily on borrowing can destroy a business, and regularly analyzing coverage ratios may prevent this from happening.
Times Interest Earned Ratio
The times interest earned ratio measures the amount of times income can cover the company’s interest payments on its debt. The more profit a company generates, the more easily it can cover its debt. This ratio paints this picture.
Calculate times interest earned by dividing earnings before interest and taxes by the interest expense.
For example, if a firm has an EBIT of $500,000 and an interest expense of $100,000, the times interest earned equals 5. This means the the company earns five times what it has to so it can meet its debt obligations. A higher times interest earned ratio is better. A value of lower than 1.5 typically indicates that the company is having difficulty paying back its creditors.
Fixed Charge Coverage Ratio
The fixed charge coverage ratio measures a company’s ability to pay all of its financial charges and expenses using income before interest or taxes. This ratio is an extension to the times interest earned ratio. Fixed cost line items such as lease payments, insurance payments, and preferred dividend payments can be added into the calculation.
The formula for this ratio is:Fixed charge coverage ratio = (EBIT + fixed charges before taxes) / (fixed charges before taxes + interest expense)
Expanding on the example above, assume the company also has $75,000 of fixed charges before taxes. The value of the ratio is:($500,000 + $75,000) / ($75,000 + $100,000) = 3.29
This shows that the company is generating 3.29 times more earnings than required to cover its financial obligation. Lenders commonly use the fixed charge coverage ratio to analyze a company’s financial health. A higher ratio indicates that the company is stronger.
Debt Service Coverage Ratio
The debt service coverage ratio compares a company’s operating income to its total debt service costs to measure its ability to service its current debts. The debt service coverage ratio takes into consideration all debt-related expenses, such as interest, principal, pension obligations, and sinking fund obligations. Because of this, it is a very important ratio for creditors as they look at a company’s ability to meet all of its debt obligations.
Calculate the debt service coverage ratio by dividing the operating income by the total debt service costs.
A higher ratio is always desirable, while a ratio lower than 1 means that the company is not generating enough profits to service debt and must resort to using savings.