DEBT COVERAGE RATIOS
Suppose you are an investor looking at purchasing a corporate bond or an analyst looking at whether a company should be given additional debt. In either case, you are concerned about the ability of the company to repay the bond or the new debt. You could probably say that is your primary concern. Four tools of financial analysis known as “coverage ratios” will help you assess the borrower’s ability to repay. These ratios are: (1) the times interest earned or interest coverage ratio (“ICR”), (2) the debt service coverage ratio (“DSCR”), (3) the cash coverage ratio (“CCR”), and (4) the fixed asset coverage ratio (“FACR”).
Coverage Ratios Help Tell a Company’s Financial Story
A company’s financial statements provide a story about the company’s financial position, and financial ratios help tell that story. The coverage ratios tell us how much earnings, or in the case of the CCR, cash flows, “cover” certain payment obligations. It bears mentioning, however, that the financial ratios will generally vary across different industries, so comparing ratios from companies in different industries may be comparing apples to oranges. Moreover, a debt coverage analysis should include a review of the trends in the company’s ratios as opposed to analysis of a single period. The time period reviewed should include good and lean years; the ratios may signal strength in good times, while masking difficulty to meet obligations in more lean periods. Visit here for more on financial ratios.
Interest Coverage Ratio
The interest coverage ratio, the ICR, assesses a company’s ability to generate sufficient earnings to make the interest payments on its debt. Put simply, the ICR is a formula the numerator of which is the company’s earnings before interest and taxes (“EBIT”) and the denominator of which is the company’s interest expense:
Times Interest Earned=(Earnings Before Interest and Taxes)/(Interest Expense)
The result is how many times company earnings “cover” the company’s interest payments, and as with all coverage ratios, the higher the ICR the better. The higher the ICR, the higher earnings are relative to interest expense, which suggests earnings will generate sufficient cash flow to cover interest, whereas an ICR below one means the company’s earnings (before interest and taxes) are not sufficient to cover the company’s interest payments. This is particularly problematic from a debt coverage perspective because, as mentioned below, the ICR only measures the company’s interest expense; if obligated principal repayments are considered, the company’s ability to service its debt is even more in question. As noted in Investopedia, creditors prefer ICRs above 2.5 or 3. Too high of an ICR, however, may indicate the company’s capital structure is underleveraged.
The currently-calculated ICR can be graphed and compared to both historical ICR measurements as well as to the ICR of competitors. Interest coverage ratios tend to differ across industries, and an ICR for a specific borrower that is significantly out of line with its competitors may be a red flag. Similarly, widely varying ICRs over time may signal problems as well.
Let’s do an example. XYZ Company has the following income statement items:
|Net Income Before Interest & Taxes||$5,500,000|
|Net Income Before Taxes||$3,500,000|
The ICR is calculated as follows:
Interest Coverage Ratio=$5,500,000/$2,000,000=2.75X
While the ICR Tells a Story, That Story is Not Complete
If you are analyzing this ratio, whether as an investor, potential lender, or analyst, you need to understand the ICR’s limits. The ICR has several shortcomings, including:
- The “earnings” in the EBIT formula is an accounting measure, which may or may not be a strong indicator of the potential borrower’s ability to generate sufficient cash to repay. Accounting profit does not equal cash! As discussed below, a second solvency ratio – the cash coverage ratio – modifies the ICR to add back non-cash items.
- Earnings is very broad, and it includes items such as disposition gain or loss or income from discontinued operations that you may not want to include to be conservative. Your focus is on whether expected, recurring, earnings can cover debt service. Similarly, you want to also account for seasonality of earnings.
- Earnings in the income statement are historical results and may not accurately reflect the future earning potential of the company. Graphing a company’s ICR over time can provide additional insight into the strength of the company’s debt service capabilities.
- The formula does not account for required principal repayments, so other coverage ratios may be used to supplement.
Note that because of these shortcomings, and those of the other ratios discussed below, a thorough liquidity analysis will look at multiple liquidity ratios and analyses to get a more complete picture of a borrower’s ability to repay its obligations. It is also important to note that debt obligations often include minimum levels for the coverage ratios. Included amongst the loan’s “covenants,” these minimum limits ensure that a company does not overextend itself financially, thereby jeopardizing its ability to repay the debt obligation.
Debt Service Coverage Ratio
The Debt Service Coverage Ratio (or DSCR) corrects one of the shortcomings of the ICR by adding principal payments to the equation and analyzes how much a borrower’s earnings cover interest AND principal payments:
Debt Service Coverage Ratio=(Earnings Before Interest and Taxes)/(Interest Expense+Debt Service)
As with the ICR, a DSCR below one means earnings are not sufficient to cover total debt service. A variation of the DSCR – the fixed charge coverage ratio – expands the denominator to include other fixed payments such as required lease payments.
Continuing with our example, let’s assume that in addition to $2,000,000 of interest expense, XYZ must make principal payments in the coming year of $350,000. The basic DSCR calculation is calculated as follows:
Debt Service Coverage Ratio=$5,500,000/(($2,000,000+$350,000) )=2.34X
We can expand the DSCR to include other fixed payments such as lease payment obligations. Assume, for purposes of the example, that XYZ’s obligations include $250,000 in fixed annual lease payments. The variation of the DSCR to include lease payments would be calculated as:
Debt Service Coverage Ratio=$5,500,000/(($2,000,000+$350,000+$250,000) )=2.12X
As in the case of the ICR, a DSCR below one would signal that the borrower may (or will likely) experience problems covering its total debt service out of its earnings.
Like the ICR, the DSCR has several shortcomings, some of which can be addressed through adjustments to the formula, as well as by adding other ratios to “round out” the picture of the company’s ability to meet its debt service obligations:
- As with the ICR, the focus of the numerator should be on the company’s recurring and regular income streams. Unusual transactions, such as dispositions may need to be removed from the numerator. So if, for example, XYZ’s net income included $1 million in gain on the sale of an asset, you would want to adjust the numerator by that $1 million since it is not a part of recurring earnings.
- Also like the ICR, the DSCR relies on accounting earnings rather than cash flow, and accounting earnings may or may not translate into the cash needed to service the company’s obligations. Nor does accounting earnings included projected capital needs, such as capital expenditures, the funds for which will not be available for debt service.
Cash Coverage Ratio
A derivation of the ICR, the cash coverage ratio, or “CCR,” addresses another shortcoming of the simple ICR by adjusting the numerator to approximate cash flow coverage for interest expense rather than EBIT. This is accomplished by adjusting the EBIT figure by the amount of non-cash items included in earnings such as, for example, depreciation:
Cash Coverage Ratio=(Earnings Before Interest and Taxes±Non Cash Items)/(Interest Expense)
Continuing with our example, note that XYZ’s income statement includes two non-cash items: depreciation and amortization. The CCR adds these items back in the numerator when assessing the company’s ability to meet its interest expense obligations:
Cash Coverage Ratio=(($5,500,000+$1,500,000))/$2,000,000=3.50X
Limits to the utility of the CCR include:
- The addition of non-cash expenditures to earnings will approximate cash flow, but the resulting figure may not be free cash flow. For example, cash may be earmarked for purposes other than debt service, such as capital expenditures, and would not be available for debt service. Alternatively, funds needed for capital expenditures may need to be shifted to debt service, leaving the company’s assets underfunded.
- Moreover, the “earnings” figure assumes 100 percent conversion to cash, which is unlikely.
- Like the ICR, the CCR only considers interest expense and does not account for principal payments or other fixed payments, such as lease payments. The CCR can be modified by using the free cash flow in the CCR numerator and dividing by total debt service payments and other fixed payments.
Fixed Asset Coverage Ratio
The final coverage ratio in our discussion – the fixed asset coverage ratio (or “FACR”) – focuses on the balance sheet rather than the income statement, and looks at coverage by total assets rather than coverage through income or cash flow. As with the other ratios, the higher the ratio the better:
FACR=(Assets (less Intangibles)-(Current Liabilities-ST Debt) )/(Total Debt)
Suppose, in our example, that XYZ has the following: (1) $10 million in assets, including $2 million of intangibles, (2) $1.25 million of short-term liabilities, and (3) $4 million in long-term debt, not including the potential $2 million loan you are considering. The FACR, including the additional debt, would be calculated as follows. Note the adjustments to both the numerator and denominator for the additional debt and proceeds from the debt:
The FACR is above one, which means assets (excluding intangibles) can cover total debt, but the fact that the ratio is relatively close to one may cause some concern and more analysis should be done to determine XYZ’s credit worthiness for the additional $2 million in debt.
The FACR is, too, subject to shortcomings, many of which can be addressed through variations to the basic formula. These shortcomings include:
- The asset side of the balance sheet is based, per accounting rules, on original cost basis, which may be greater than or less than market value and may not reflect the value at which they could be converted into cash.
- Moreover, total assets will likely include, in addition to intangibles such as goodwill, other non-liquid assets that could not be easily converted into cash to use for debt service.
The debt coverage ratios are convenient ways to analyze a company’s ability to service debt. Each ratio has its weaknesses, however, and a thorough analysis will include multiple ratios as well as a thorough study of the target company’s credit worthiness.