What is the Coverage Ratio?
A coverage ratio divides a company's income or cash flow by a certain expense in order to determine financial solvency.
How Does the Coverage Ratio Work?
Some of the most common coverage ratios include the fixed-charge coverage ratio, debt service coverage ratio, times interest earned (TIE), and the interest coverage ratio. However, many measures of a company's ability to meet a certain financial obligation can be deemed coverage ratios.
In general, coverage ratios equal to or greater than 1.0 indicate that a company has enough earnings or cash to meet the obligation in question. Coverage ratios below 1.0 indicate that a company may not be able to fulfill these obligations.
Why Does the Coverage Ratio Matter?
Coverage ratios measure a company's ability to pay certain expenses, and thus show some aspects of a company's financial strength. However, because coverage ratios typically include current earnings and current expenses, they usually only describe a company's short-term ability to meet obligations.
Although certain coverage-ratio formulas may vary from company to company, SEC Regulation G requires public companies to disclose their methods for calculating them and other non-GAAP financial measures. Additionally, coverage ratio standards vary from industry to industry, and comparisons of coverage ratios is generally most meaningful among companies within the same industry. Thus, the definition of a 'high' or 'low' ratio should be made within this context.
