Coverage Ratios: Is Your Company a Little Exposed?

Coverage ratios are designed to measure how well a company is able to meet the demands of its operational expenses and debt requirements. They are similar yet different from leverage ratios. In leverage ratios, we measure the lender’s margin of comfort in the event of liquidation. Coverage ratios indicate the cash flow margin of the company as a going concern. Highly leveraged companies or businesses with high debt requirements are vulnerable to an economic downturn or a drop in top line sales, because the fixed payments from the debts may conflict with the reduced cash flow from the falling sales. The company will have to do whatever they can to provide cash to satisfy their obligations. Ultimately, an answer will be to find a way to de-lever the company and reduce its obligations.

Times Interest Earned Ratio (Interest Coverage) is used to show the ability of the company to meet its interest obligations. It is used a lot by public bond rating agencies and banks monitoring revolving lines of credit, revealing the amount of company earnings needed to pay interest on its debt. The reason for the focus on just the interest rate exposure is that many bonds and lines of credit do not require any amortization.

Since it does not take into account the principal portion of payments, the ratio will have its shortcomings. But it is a valuable picture of what impact an increase in borrowing rates will have on the company’s cash flow and the extent which earnings pay the financing requirements of the firm. The ratio must be at least greater than one, since a ratio below one will indicate the company does not make enough net cash flow to pay its interest requirements. This is the case in several European countries now.

The ratio is as follows:  (Net Income Before Taxes + Interest Expense) / Interest Expense

Debt Service Coverage Ratio is the granddaddy of the coverage ratios in the eyes of the lender. This measures the ability of the company to perform on its debt obligations. In simple terms, it is defined as:  Earnings Before Interest, Taxes, Depreciation and Amortization (EBIDTA) / (Interest Expense + Current Portion of Long Term Debt (CPLTD))

This is designed to show, after paying all the operational expenses of the business, how does the debt requirements compare with the EBIDTA. A ratio of 1:1 would indicate that the company is able to pay all its obligations but has no money for anything else. Lenders will often use this as a loan covenant or measuring tool to assess the health of the business. They will also have different thresholds for different industries, ages of collateral and types of collateral.

There are some concerns with this ratio. If a company makes large capital improvements and then expenses them, this could lower their EBIDTA to a point where they may be in violation of their loan covenant. A prudent solution is to keep separate financials according to GAAP while having another set that complies with the tax law. An example here would be a manufacturer who is able to fully expense $200K in capital improvements to their plant under repair and maintenance in the year the work was completed. This reduction in EBIDTA may put the company in violation of the DSCR requirement.

A shortcoming with using the DSCR is that the expenses for taxes are real cash expenses. Using the DSCR they are not regarded at all. Another problem with using EBIDTA is if a business has regular ongoing capital expenses each year, necessary to continue operations. Ignoring those expenses may show an adequate DSCR, but miss the overall shortfalls of cash needs the company may have in order to keep operations intact.

Another issue with DSCR is how to treat large salaries or personal expenses of the owners. These would be treated as ongoing operational expenses, but if excessive, may show the company in a worse light than what it is. If the excessive salaries are added back, then a look at the global picture of the owners, the subject company and their other businesses may be appropriate in judging the financial ability of the company.

Funded Debt/EBIDTA Ratio and the Debt Yield are used by some banks to see a comparison of the balance of all funded debts to EBIDTA. The ratio for Funded Debt/EBIDTA is:  Balance of all Funded Debt / EBIDTA = Funded Debt to EBIDTA ratio.

If you have a company with a ratio of 2, this would mean that the entire balance of all funded debt is only twice the amount of EBIDTA. The reciprocal of this is the Debt Yield which is figured by:

EBIDTA / Funded Debt = Debt Yield and is usually expressed as a percentage. So if we have a ratio of 2:1 in the above ratio, this one would be 50%. These ratios are used by some lenders to judge the amount of leverage compared to the net operating income of the company.