Companies use two forms of finance to fund their operations. These include equity and debt finance. Equity finance is straightforward and comes from the company’s shareholders.
Usually, this finance does not carry any interest. However, companies have to pay dividends to shareholders. But these dividends are only applicable when the company is profitable.
When it comes to debt finance, however, companies must pay interest. This interest is an obligation for companies. There is no requirement for a company to be profitable to pay interest on debt finance.
However, this creates some complications for companies, particularly loss-making ones. Furthermore, companies that don’t make profits are usually short on cash. Therefore, the cash may not cover those interest payments.
What is a Coverage Ratio?
A coverage ratio is a financial ratio used to measure a company’s ability to repay financial obligations. Several coverage ratios look at how companies can cover those obligations.
Usually, coverage ratios consider two primary financial obligations. These include dividends and interest payments.
Most companies strive for the coverage ratios to be high. Higher coverage ratios indicate a better ability to repay financial obligations.
However, these ratios may differ from one industry to another. On top of that, some companies may have more obligations while others are lower. Furthermore, each ratio may have differing levels for what companies consider ideal for the specific ratio.
Coverage ratios are crucial for both companies and stakeholders. Most importantly, these are critical for parties associated with financial obligations.
These primarily include shareholders, investors, and creditors. When obtaining finance, most lenders consider the coverage ratios before deciding. As mentioned, several coverage ratios may be of interest to these parties.
What are the primary Coverage Ratios?
There are several variations of the coverage ratios. These explore various aspects of a company’s ability to repay financial obligations.
The most prevalent of these includes the interest coverage ratio. This ratio calculates the ability of a company to cover interest expenses from its profits. Usually, it considers a company’s earnings before interest and tax.
Another coverage ratio is the debt service coverage ratio. It looks at whether a company can repay its entire debt service from its profits.
The debt service includes all principal and interest payments in the near term. This ratio considers the net operation profits rather than the EBIT. For some stakeholders, the asset coverage ratio may also be of value.
The asset coverage ratio only considers a company’s ability to repay debts using total assets minus short-term liabilities.
However, some stakeholders focus on a company’s cash resources more than its total assets. While the asset coverage ratio may include cash, it also considers other resources. For those stakeholders, the cash coverage ratio is more crucial.
What is the Cash Coverage Ratio?
The cash coverage ratio is a metric that helps entities calculate the ability to make interest payments using existing cash.
It is similar to the interest coverage ratio, which examines whether companies can repay the interest expense. The cash coverage ratio focuses on whether companies have enough cash resources to cover interest payments.
Like other coverage ratios, the higher the cash coverage ratio is, the better it is for companies. A higher ratio indicates that a company has enough cash resources to satisfy interest expenses.
Although the interest expenses may include accrued interest, it is still crucial for companies to own resources to cover them. Usually, stakeholders prefer the cash coverage ratio to be significantly higher than 1.
The cash coverage ratio is one of the favorite ratios for lenders and creditors. Since this ratio primarily focuses on interest expense and cash resources, it can indicate financial difficulties.
Based on this information, lenders decide whether they should provide finance to borrowers. By removing non-cash assets from the calculation, stakeholders can get better insights into the company’s resources.
How do you calculate the Cash Coverage Ratio?
Calculating the cash coverage ratio is straightforward. It requires stakeholders to divide a company’s earnings before interest and taxes after adding non-cash expenses by its interest expense. Therefore, the cash coverage ratio will be as follows.
Cash Coverage Ratio = (Earnings Before Interest and Taxes + Non-Cash Expenses) / Interest Expense
A company’s earnings before interest, taxes, and non-cash expenses are available in the income statement. However, acquiring the non-cash expenses may not be straightforward.
Similarly, the interest expense is also available in the income statement. Some of these figures may also be available in the notes to the financial statements.
However, there is an alternative formula for the cash coverage ratio. This alternative is more straightforward compared to the above option, as below.
Cash Coverage Ratio = Total Cash / Total Interest Expense
The above formula uses a company’s total cash instead of earnings before interest and taxes. Similarly, it does not require companies to include non-cash expenses in the calculation.
The total cash figure in the above formula is usually available in a company’s balance sheet. This figure includes all the cash and cash equivalent that a company has available. Therefore, the calculation is more straightforward.
ABC Co. reported Earnings Before Income and Taxes (EBIT) of $40 million in its income statement. The company’s non-cash expenses for the period amounted to $10 million.
Similarly, ABC Co.’s income statement included an interest expense of $25 million. Therefore, ABC Co.’s cash coverage ratio will be as follows.
Cash Coverage Ratio = (Earnings Before Interest and Taxes + Non-Cash Expenses) / Interest Expense
Cash Coverage Ratio = ($40 million + $10 million) / $25 million
Cash Coverage Ratio = 2.0
The above ratio indicates ABC Co. has twice the cash resources required to cover its interest expense. As mentioned, most stakeholders prefer this ratio to be more than 1.
Therefore, ABC Co.’s cash coverage ratio of 2.0 clears that threshold. However, this ratio does not indicate how the company performs compared to its competitors or industry. Stakeholders need to make a comparative analysis to get more information.
What is the importance of the Cash Coverage Ratio?
The cash coverage ratio is of significant importance for companies and stakeholders. Most importantly, this ratio provides creditors with critical information regarding a company’s ability to repay debt.
Using this information, creditors can decide whether to provide a company with a loan. Furthermore, it also dictates the terms lenders will imply on their loans.
For companies, internally, the cash coverage ratio is also critical. Companies can identify opportunities to improve their cash flows by calculating this ratio.
Companies can then improve their income and profits to increase this ratio. By doing so, companies can also increase the cash coverage ratio and attract new investors.
The cash coverage ratio also provides significant insights into a company’s liquidity position. If this ratio is low, it implies that the company does not have enough resources to cover its interest obligations. It can be a red flag for stakeholders when investing in the company.
However, stakeholders must compare this information with similar companies to obtain better information.
What is a Good Cash Coverage Ratio?
A cash coverage ratio measures the ability of a company to use its existing cash reserves to cover its short-term debts. It is typically calculated by dividing a company’s total current assets by its current liabilities.
A higher cash coverage ratio indicates that the company has adequate resources to pay off its short-term obligations and is generally considered healthier than companies with lower ratios.
Ideally, investors look for companies with a cash coverage ratio of two or higher. This suggests that the business can easily afford to pay off its current liabilities without borrowing money from outside sources or selling off its assets.
Companies with ratios below one may need to seek alternative methods for covering their debts and should be closely monitored for ways in which they could improve their financial status.
In addition to measuring liquidity and solvency, a high cash coverage ratio also indicates that management is taking steps to ensure that there are enough resources available for growth and strategic investments in the future.
Companies with high ratios tend to attract more investors, showing that management is taking proactive steps toward managing their funds responsibly.
Cash Coverage Ratio Vs. Times Interest Earned: What are the Different?
Cash coverage ratio and times interest earned are two important metrics used to measure a company’s financial health. Both ratios provide insight into a company’s ability to pay its debts in the short term.
Understanding these two metrics’ distinctions can help investors make more informed decisions when evaluating potential investments.
The cash coverage ratio, also known as the current ratio, is calculated by dividing total current assets by total current liabilities.
This indicates how well a company can cover its short-term debts with its liquid assets and indicates how much leverage the company may have over other creditors.
Generally, companies with higher cash coverage ratios are considered less risky for investors as they have a larger cushion of resources available to meet their obligations.
The times interest earned (TIE) ratio, on the other hand, measures a company’s ability to service its long-term debt without resorting to financing options such as additional borrowing or asset sales.
To calculate this ratio, you take the company’s operating income before tax and divide it by its nonoperating expenses, including interest payments and amortization costs over the same period.
Typically, a TIE ratio above 3 indicates that the business has sufficient operating income to cover its long-term debt obligations multiple times.
Ultimately, both metrics give investors valuable information about a company’s liquidity and solvency which can help them evaluate their potential risk when investing in any given business.
By understanding both cash coverage ratio and TIE ratios, investors can better assess whether or not a potential investment is right for them based on their risk appetite and goals.
How to Decrease Cash Coverage Ratio?
The cash coverage ratio is essential for assessing a company’s financial health and stability. Companies with higher ratios indicate that they have more resources available to cover their short-term obligations, while companies with lower ratios may be more precarious. Here are six ways to decrease the cash coverage ratio:
- Increase Accounts Payable: By delaying payments and using credit terms offered by suppliers, and companies can increase their accounts payable balance, reducing the denominator in the cash coverage ratio formula.
- Raise Funds through Equities: Issuing additional equity shares and raising funds is one way to reduce the cash coverage ratio, as it increases the amount of funds available without increasing liabilities.
- Donate Surplus Assets: Companies can donate any surplus assets they may have instead of liquidating them, thus reducing their asset holdings without incurring any expenses or losses.
- Take-Out Loans: Taking out loans can give a company access to additional funds that can be used to pay off debts, thus reducing the cash coverage ratio by increasing liabilities and decreasing assets simultaneously.
- Reduce Operating Expenses: By cutting back on operating expenses such as marketing, entertainment, and travel costs, companies can have more money available for paying off debts without having to resort to selling assets or raising capital from outside sources.
- Lower Inventory Levels: Reducing inventory levels will decrease the amount of cash tied up in stock, freeing up funds that can be used for other purposes, such as debt reduction or strategic investments in growth opportunities.
Coverage ratios allow stakeholders to measure a company’s ability to pay financial obligations. Several coverage ratios look at different aspects of a company’s resources and obligations.
The cash coverage ratio focuses on whether a company has enough cash resources to cover interest expenses. The cash coverage ratio has a high significance, as mentioned above.