Coverage ratio is a way to measure a company's solvency to repay interest on loans. It is calculated as follows: the firm’s profit is divided by the total debt payable (interest on loans and taxes).
The extremely low ratio means that the company is not able to take care of paying interest in the near future, it still has the capital in reserve for everyday operations or unforeseen expenses.
Coverage ratio is an excellent method for investors to determine the financial stability of enterprises. The payment of interest on loans for most of them is an extremely important indicator of successful development. Failure to pay interest on any loans is a sign of weakness, a debt burden, and may be a harbinger of a possible bankruptcy of the business.
Sometimes coverage ratio investment , based on the ratio of interest received, is designed to show how long it will take the company to pay interest. This can be a great indicator of an organization’s short-term financial strength.
When calculating the interest received for a company, the profit before interest and taxes should be summarized. The resulting number is then divided by the total payable percentage (for all debts). Both numbers are taken for accuracy in accordance with a predetermined period of time for calculations. For example, an enterprise accumulates profit in a certain period of time of 50,000 rubles. This is the amount it earned before taxes and interest on loans were paid. For the same period, the interest due is 20,000 rubles. It is necessary to divide 50,000 (rubles) by 20,000 (rubles). Coverage ratio will be 2.5, which essentially means the following: the company is able to pay interest obligations 2.5 times before the capital runs out.
A low ratio, suppose if it drops to the base level of 1.0, can be problematic, but so far the company's profits (before paying interest and taxes) are enough to pay off their interest expenses. Below 1.0 indicates that the business is having difficulty generating the cash necessary to pay interest on loans. While there are some guidelines, there is no absolute or reference number that will serve as a guide for an acceptable CP.
For enterprises with unstable sectors, as a rule, a higher ratio is required in order to control the potential ups and downs as much as possible, while in stable industries it can be low. It is not good when the company has at times excessively high interest received. This means that she spent too much of her capital, paying cash for debts instead of investing in the development and expansion of the business.
To determine whether the company has a sufficient amount of liquid assets (excluding slowly sold reserves) for the payment of short-term liabilities (current liabilities), a refined (or intermediate) ratio is used coverings . Liquid assets include working capital stocks that can quickly be converted to cash close to the carrying amount. Enterprises with a liquidity ratio of less than 1.0 are not able to pay off current debts.
For bondholders, the coverage ratio is supposedly acting as a security tool. It gives an understanding of how much a company’s profit may fall before it can’t fulfill its payment obligations. For shareholders, it is important because it shows a clear picture of the short-term financial health of the business.