A coverage ratio is a type of financial ratio. It indicates the ability of a firm to pay off outsiders’ obligations. Normally, a ratio greater than 1 implies a sound position of a firm to pay off the liability or obligation under concern. Important types of coverage ratios include debt service coverage ratio (DSCR), interest coverage ratio, dividend coverage ratio, and total cash flow coverage.
Coverage ratios are essential financial ratios from the viewpoint of the long-term creditors and lenders. It is because the ratios speak about the ability of the firm to pay off the obligations of creditors & lenders. On the basis of these ratios, the creditors or lenders decide on whether to extend credit or loan or any financial support to the firm or not.
Different stakeholders calculate different coverage ratios of a business. For example, a financial institution or bank extending a loan to a business will calculate the DSCR and interest service coverage ratio. And an investor, say, an equity shareholder will look at the dividend coverage ratio.
Types of Coverage Ratios
There are five major types of coverage ratios. They are as below:
Debt Service Coverage Ratio
Debt Service Coverage Ratio (DSCR) is one of the coverage ratios calculated to know the cash profit availability to repay the debt, including interest. Essentially, a bank/financial institution/any other loan provider calculates DSCR when a company takes a loan from them. This ratio suggests the capability of cash profits to meet the financial loan repayment. DSCR is very important from the viewpoint of the financing authority as it indicates the repaying ability of the entity taking a loan.
Interest Service Coverage Ratio (ISCR) essentially calculates the capacity of a borrower to repay the interest on borrowings. ISCR less than 1 suggests the inability of the firm’s profits to serve its interest on debt and the debt amount. 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 the interest coverage ratio or times interest earned.
The dividend coverage ratio essentially calculates the capacity of the firm to pay the dividend. Generally, shareholders and especially preference shareholders, calculate this ratio. Preference shareholders have the right to receive dividends. The dividends may be postponed, but payment is compulsory, and therefore they are considered a fixed liability.
The total fixed charge coverage ratio can be called 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 the dividend coverage ratio covers only the dividend of the preference share, this ratio takes into account all the fixed obligation.
The total cash flow coverage ratio is a coverage ratio that considers the cash flows in place of the profits. It is because the company pays off all kinds of fixed charges from its operating cash flow and not from the profits. It sounds more appropriate to use cash flow as the numerator instead of profits. Profits may be a result of non-cash transactions in the earnings statements.
The asset coverage ratio tells how much a company’s assets are efficient in paying off dividends. In this ratio, the numerator changes to the company’s net assets. A higher asset coverage ratio is better.
The coverage ratio calculation has earnings/cash flow as the numerator. And the denominator consists of the liability or the fixed charge, which is the purpose behind calculating such ratios. Usually, a ratio higher than one indicates that the earnings or cash flows are sufficient to pay off the liabilities.
You can also refer to Ratio Analysis for other types of ratios.
Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.
