The coverage ratio measures the firm’s ability to service (repay) the fixed liabilities. These ratios establish the relationship between fixed claims and what is normally available out of which these claims are to be paid. These fixed claims may consist of interest on loans, dividend on preference shares, amortisation of principal or repayment of instalments of loans or redemption of preference capital.
Generally, banks, financial institutions and other lenders are interested to know if the firm is financially solvent enough to repay their funds in coming time. This is the test of long term solvency rather than short-term which we cover under liquidity ratios. Loans are usually taken for a longer duration. Hence, the assessment of long term repayment capacity and sources becomes mandatory.
Following are the most popular coverage ratios:
1. Debt Service Coverage Ratio
Lenders are interested in the debt service coverage to judge the firm’s ability to pay off current interest and loan instalments.
Debt service coverage ratio is computed as below:
Earning available for total debt service (or EBIT)/ Interest Expenses+Loan Instalments
Here, earning available for debt service = Net profit+Non-cash operating expenses (such as depreciation and amortisations) + Non-operating adjustments to income (such as gain or loss on the sale of fixed assets) +Interest on debt funds
Another easy to under formula:
Cash flow from operating activities+Interest Expenses /Principal payments+Interest payments
2. Interest Coverage Ratio
3. Preference Dividend Coverage Ratio
Preference Dividend Coverage Ratio = Profit After Tax (PAT) / Preference Dividend Liabilities
4. Capital Gearing Ratios
Capital gearing ratio, or sometimes also called a gearing ratio only, expresses the relationship of total internal capital to total external capital. Here, external capital refers to fixed charge bearing securities which also include preference shares, apart from interest-bearing bonds, debentures etc. as the business has to pay them fixed dividends. Only equity and equity funds are considered internal capital.