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Saturday, 28 January 2012

Financial Ratio Analysis: Coverage Ratio

Coverage Ratio is a measure of a company's ability to meet its financial obligations.
The higher the coverage Ratio, the better the ability of the enterprise to fulfill its obligations to its lenders.

Coverage Ratio includes

1.Interest Coverage Ratio
2.Debt Service Coverage Ratio
3.Asset Coverage Ratio

Interest Coverage Ratio:Interest Coverage Ratio measure the ability of a company to pay the interest expense on its debt.
This ratio is used to determine how easily a company can pay interest on outstanding debt.
Interest Coverage Ratio is calculated by dividing a company's earnings before interest and taxes(EBIT) of one period by the company's interest expenses of the same period.

Interest Coverage Ratio =EBIT/Interest Expense

An interest Coverage Ratio below 1 indicates the company is not generating sufficient revenues to satisfy interest expenses.

2.Debt services Coverage Ratio:It is also known as Debt Coverage Ratio.It is the measure of a company's ability to produce enough cash to cover its debt(including lease) payments.
DCR(Debt Coverage Ratio) is the ratio of cash available for debt servicing to interest,principal and lease payments.

Debt Coverage Ratio=Net Operating Income/Total Debt Services

Debt service Coverage Ratio of less than 1 would mean a negative cash flow.The higher DCR is better.

3.Asset Coverage Ratio:Asset Coverage Ratio determines a company's ability to cover debt obligations with its assets after all liabilities have been satisfied.
This ratio tells us how much of the assets of a company will be required to cover its outstanding debts.

Asset Coverage Ratio=((BV Total Assets-Intangible assets)-(current liabilities-ST Debt obligations))/Total debt outstanding

BV=Book Value
ST=Short Term

Utilities should have an Asset Coverage Ratio of at least 1.5
Industrial Company's should have a ratio of at least 2.

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