## Leverage Ratios — II. Coverage Ratios
Coverage ratios measure a firm's ability to service its fixed liabilities — linking the fixed claims to the earnings available to meet them. Fixed claims consist of:
- Interest on loans
- Preference dividend
- Amortisation of principal / instalment repayment / redemption of preference capital on maturity.
### A. Debt Service Coverage Ratio (DSCR)
$$\text{DSCR} = \frac{\text{Earnings available for Debt Service}}{\text{Interest} + \text{Installments}}$$
- Earnings available for Debt Service = Net profit (EAT) + non-cash operating expenses (depreciation, amortisation) + Interest + other adjustments (e.g. loss on sale of fixed asset).
- Normally 1.5 to 2 is satisfactory. Lenders use it to judge ability to pay current interest and instalments.
- Note: funds/cash from operations before interest and tax may also be used as the numerator depending on the requirement.
### B. Interest Coverage Ratio (Times Interest Earned)
$$= \frac{\text{EBIT}}{\text{Interest}}$$
- How many times earnings cover the interest bill. High ratio → can meet interest even if EBIT falls sharply; low ratio → excessive debt or inefficient operations.
### C. Preference Dividend Coverage Ratio
$$= \frac{\text{Net Profit / Earnings after Tax (EAT)}}{\text{Preference Dividend}}$$
- Margin of safety for preference shareholders; higher is better.
- Note: the numerator is EAT — because preference dividend is paid out of post-tax profit.
Related: Equity Dividend Coverage $= \dfrac{\text{EAT} - \text{Preference Dividend}}{\text{Equity Dividend}}$
### D. Fixed Charges Coverage Ratio
$$= \frac{\text{EBIT} + \text{Depreciation}}{\text{Interest} + \text{Repayment of Loan}}$$
- How many times cash flow before interest and tax covers all fixed financing charges; > 1 is considered safe.
### Doubt Busters (terminology & exam practice)
1. EBIT = PBIT, EAT = PAT, EBT = PBT — these pairs are interchangeable.
2. Ratios are computed based on requirement and availability of information and may deviate from the textbook formula — state your assumptions.
3. The numerator must correspond to the denominator and vice-versa.