Article on Coverage Ratios - Analysis of Financial Statements There are three significant coverage ratios which students must

learn and apply while calculating financial ratios for companies. They are explained as under. (a) Interest Coverage Ratio While doing financial statement analysis for a company, interest coverage ratio is an important ratio to be calculated to check whether the company is capable of paying interest on the debt taken from the third parties. It is also known as times interest earned ratio. It is defined as below. Profit before interest and taxes Interest It is to be noted that profit before interest and taxes are placed in the numerator for this ratio since the capacity of a firm to pay interest is not affected by payment of tax as interest on debt is a tax deductible cost. A high interest coverage ratio denotes the firm can meet out its interest cost with ease even if earnings before interest and tax undergo a substantial decrease. Conversely, a low interest coverage ratio may result in financial humiliation when earnings before interest and taxes diminish. This ratio is extensively used by financiers to evaluate a firms debt capability. Even though this ratio is extensively used, is not very accurate weight of interest coverage since the basis of interest payment is cash flow before interest and tax and not earnings before interest and tax. Hence the ratio can be modified and defined as below. Profit before interest and tax + depreciation Debt interest (b) Fixed Charges Coverage Ratio This ratio represents the number of times the cash flow before interest and taxes covers all fixed financing expenses. It is denoted as below. Profit before interest and taxes + depreciation Interest + (Repayment of loan/1-tax rate) Here, if we note the denominator, only the repayment of loan is amended upwards for tax aspect since the loan repayment amount dissimilar to interest is not a tax deductible item. This ratio determines the debt servicing capacity methodically since it includes both interest and the principal repayment commitments. The ratio may be augmented to consider other fixed expenses like payment of lease amount and payment of preference dividend. The fixed expense coverage ratio has to be understood with concern since short term loans like commercial paper and working capital is inclined to be self-restoring in nature and therefore do not have to be usually repaid from cash flows originated by operations. Hence, a fixed interest expense coverage ratio of less than 1 not necessarily is viewed with much apprehension.

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(c) Debt Service Coverage Ratio Students must note that this ratio is another important ratio to be computed for financial analysis. This ratio is defined as below. (Earnings after tax + depreciation + other non-cash expenses+ interest on term loan + Amount of lease rentals) / Interest on term loan + lease rentals + repayment of term loan Financial establishments compute the average debt service coverage ratio for the period for the duration of which the term loan for the project is repayable. Usually, financial establishments consider a debt service coverage ratio of 1.50 to 2.0 as acceptable.

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