What is a coverage ratio?
Coverage ratios, commonly referred to as debt ratios, are measures used in accounting[1] to determine the ability of a business to cover its debt obligations, including capital and interest payments, to its creditors and lenders.
Types of coverage ratios
Coverage ratios include, among others, the following ratios:
- Debt ratio
- Debt-to-equity ratio
- Asset coverage ratio
- Debt-service coverage ratio
- Interest coverage ratio/Times interest earned ratio
Debt ratio
- What the debt ratio determines
The debt ratio, also known as the debt to asset ratio or the total debt to total assets ratio, determines what portion of a company’s total assets are financed by debt allowed by lenders and creditors. Put differently, the ratio indicates the percentage of total assets that is owed to creditors and lenders.
To finance assets with debt is called leverage or financial leverage in the world of businesses.
- Formula
Debt ratio = Total debt/Total assets
The formula is expressed as a decimal or percentage.
- Example
Company AAA’s balance sheet shows total assets of R500 000 and total liabilities of R220 000.
The company’s debt ratio is: R220 000/R500 000
= 0.44 or 44%
A debt ratio higher than 100% is an indication that a business has more debt than assets. Conversely, a debt ratio of less than 100% shows that the business’s total assets exceed its total debt.
The higher the debt ratio, the more a business utilises leverage, which implies more financial risk. However, high debt ratios are not bad per se, because leverage is an important strategy implemented by many companies to stimulate growth.
Debt ratios differ considerably across industries. For instance, capital-intensive businesses have much higher debt ratios than businesses in the service industry.
Debt-to-equity (D/E) ratio
- What the ratio indicates
The debt-to-equity (D/E) ratio is an important metric used by businesses, indicating whether a business is able to cover all of its outstanding debts by its shareholders’ equity in the event of a business decline.
In other words, the D/E ratio compares a company’s total liabilities (debt) to its shareholders’ equity, evaluating how much the company is leveraged.
- Formula
Debt-to-equity ratio = Total liabilities/Shareholders’ equity
- Example
At the end of its previous financial year, company ABC had total liabilities of R3 000 000 and total shareholders’ equity of R6 500 000.
Hence, ABC’s debt-to-equity ratio for the particular financial year was:
R3 000 000/R6 500 000
= 0.46
The ratio of 0.46 will be considered relatively safe. Generally, D/E ratios less than 1.0 would be viewed as relatively safe, while ratios of 2.0 or more, would be regarded as risky.
Although, a safe or risky D/E ratio will depend on the type of business and the nature of its industry.
Sometimes, analysts or investors will modify the ratio to exclude short-term liabilities such as payables and other types of short-term debt. The reason for the modification of the D/E ratio is that long-term liabilities entail different risks than short-term liabilities.
Asset coverage ratio (ACR)
- What the asset coverage ratio measures
The asset coverage ratio (ACR) measures whether a business will be able to pay back its debt obligations with its tangible assets after it has honoured its short-term debt such as accounts payable.
- Formula
Asset coverage ratio = ((Total assets – Intangible assets) – (Current liabilities – Short-term debt))/Total debt obligations
A disadvantage of this ratio is that it depends on the book value of a business’s assets, which will often differ from the actual market value.
Example
Company WWW’s financial figures include:
- Total assets: R200 million
- Intangible assets: R25 million
- Current liabilities: R40 million
- Short-term debt: R 25 million
- Total debt obligations: R120 million
Company WWW’s ACR will look as follows:
((R200 million – R25 million) – (R40 million – R25 million))/R120 million
= (R175 million – R15 million)/R120 million
= R160 million/R120 million
= 1.33
Hence, the company will pay off all its debt obligations without selling all of its assets. An ACR of 1 would imply that the company would just be able to cover all its debt by selling all its assets.
Debt-service coverage ratio (DSCR)
- What the DSCR shows
The debt-service coverage ratio (DSCR) shows a business’s ability to repay its current debts, also referred to as short-term debts, including interest payments.
The ratio compares its net operating income (NOI), also known as net operating profit, with its total debt service obligations. Net income refers to a business’s revenue less all operating expenses (OPEX) that are incurred by a business through its normal business operations. NOI excludes expenses such as taxes, depreciation, amortisation, interest, or capital expenses (CAPEX).
- Formula
Debt-service coverage ratio = Net operating income/Total debt service obligations
- Example
A company’s financial statements reflect, inter alia, the following financial figures:
- Net operating income: R550 000
- Interest expenses: R120 000
- Principal debt payments: R170 000
The company’s DSCR will be calculated as follows:
DSCR = R550 000/(R120 000 + R170 000)
= R550 000/R290 000
= 1.9
Thus, the company would be able to cover its debt obligations (principal and interest) 1.9x over with its net operating income. A DSCR of below 1 indicates a business’s inability to honour its debt obligations. For instance, if the company’s DSCR is 0.8, it means that only 80% of its debt obligations would be covered by its net operating income.
Generally, a suitable debt-service coverage ratio is 2 or higher.
Interest coverage ratio (ICR)
- What the ICR indicates
The interest coverage ratio (ICR), also called the times interest earned ratio, indicates how frequently a business is able to pay the interest due on its debt with its operating income.
Operating income, also referred to as operating profit or recurring profit, refers to a business’s gross income less all the operating expenses. Operating income is equivalent to earnings before interest and taxes (EBIT).
- Formula
Interest coverage ratio = Operating income/Interest expense
- Example
A business reports an operating income of R600 000. Its liability for interest payments amounts to R75 000.
Its ICR will look as follows:
ICR = R600 000/R75 000
= 8
Hence, the business would be able to satisfy its interest payments 8x over with its operating income.
Typically, an interest coverage ratio of 1.5 is regarded the minimum acceptable ratio. Any figure below 1.5 may indicate default risk.
[1] Refer the article, ‘Accounting Ratios Explained for Dummies’, for an overview of the numerous ratios used in accounting.
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