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 ones that are loss-making. 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. There are several coverage ratios that look at different aspects of 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 making a decision. As mentioned, there are several coverage ratios that 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.

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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 make decisions on 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.

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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 and 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 as well. 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 the 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.

Example

A company, 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 that 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.

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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 make decisions regarding whether to provide a company with a loan. Furthermore, it also dictates the terms that lenders will imply on their loans.

For companies, internally, the cash coverage ratio is also critical. By calculating this ratio, companies can identify opportunities to improve their cash flows. Companies can then work on enhancing 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 will need to compare this information with other similar companies to obtain better information.

Conclusion

Coverage ratios allow stakeholders to measure a company’s ability to pay financial obligations. There are several coverage ratios that 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.