A Coverage ratio is a type of financial ratio. It indicates the ability of a firm to pay off the outsiders obligations. Normally, a ratio greater than 1 implies sound position of a firm to pay off the liability or obligation under concern. Important coverage ratios include debt service coverage ratio, interest coverage ratio, dividend coverage ratio, and total cash flow coverage.
Coverage ratios are important financial ratios from the view point of the long term creditors and lenders. It is because the ratios speak of the ability of the firm to pay off the obligations of creditors and lenders. On the basis of the ratios, the creditors or lenders take a decision on whether to extend credit or loan or whatever kind of financial support to the firm or not.
Different coverage ratios are calculated by different stakeholders of a business. For example, a financial institution or bank extending a loan to the business or firm will calculate the debt service coverage ratio and interest service coverage ratio and an investor say equity shareholder will look at the dividend coverage ratio.
Types of Coverage Ratios:
There are major 5 types of coverage ratios. They are briefed below:
- Debt Service Coverage Ratio: Debt Service Coverage ratio (DSCR), one of the leverage / coverage ratios, calculated in order to know the cash profit availability to repay the debt including interest. Essentially, DSCR is calculated when a company / firm takes loan from bank / financial institution / any other loan provider. This ratio suggests the capability of cash profits to meet the repayment of the financial loan. DSCR is very important from the view point of the financing authority as it indicates repaying capability of the entity taking loan.
- Interest Service Coverage Ratio: Interest service coverage ratio (ISCR) essentially calculates the capacity of a borrower to repay the interest on borrowings. ISCR less than 1 suggests inability of firm’s profits to serve its interest on debts and obviously the debts. ISCR is a tool for financial institutions to judge the capacity of a borrower to repay the interest on the loan. It is also known as Interest Coverage Ratio or Times Interest Earned.
- Dividend Coverage Ratio: Dividend coverage ratio essentially calculates the capacity of the firm to pay dividend. Generally, this ratio is calculated specifically for preference equity shareholders. Preference shareholders have right to receive dividends. The dividends may be postponed but payment is compulsory and therefore they are considered as a fixed liability.
- Total Fixed Charge Coverage Ratio: Total fixed charge coverage ratio can be called as a consolidated ratio of all the fixed charges such as preference share dividend, interest, installment, lease payments etc. Unlike, the other coverage ratios which cover a specific fixed charge like dividend coverage ratio covers only dividend of preference share, this ratio takes into account all the fixed obligation.
Calculation and Interpretation of Coverage Ratio:
The calculation of coverage ratio has earnings / cash flow as the numerator and the denominator consist of the liability or the fixed charge for which the ratio is being calculated. Normally, a ratio higher than 1 indicates that the earnings or cash flows are sufficient to pay off the liabilities for which the ratio is calculated.