## Coverage Ratios
Coverage ratios measure a firm's ability to service its fixed financial obligations — interest, preference dividends, and loan repayments — out of its earnings or cash flows. A higher coverage ratio generally signals a greater margin of safety for lenders and preference shareholders.
### A. Interest Coverage Ratio
Also called the "times interest earned" ratio. It indicates the firm's ability to meet interest (and other fixed charges) obligations — i.e. how many times current earnings can cover the current interest payment.
$$\text{Interest Coverage Ratio} = \frac{\text{Earnings before Interest and Taxes (EBIT)}}{\text{Interest}}$$
- High ratio → the firm can comfortably meet interest even if EBIT falls considerably.
- Low ratio → excessive use of debt or inefficient operations.
### B. Preference Dividend Coverage Ratio
Measures the firm's ability to pay dividend on preference shares (which carry a stated rate of return). It shows the margin of safety to preference shareholders — a higher ratio is desirable from their viewpoint.
$$\text{Preference Dividend Coverage Ratio} = \frac{\text{Net Profit / Earnings after taxes (EAT)}}{\text{Preference Dividend}}$$
### C. Equity Dividend Coverage Ratio
Measures the cushion available for paying equity dividend after preference dividend is met.
$$\text{Equity Dividend Coverage Ratio} = \frac{\text{EAT} - \text{Preference Dividend}}{\text{Equity Dividend}}$$
### D. Fixed Charges Coverage Ratio
Shows how many times the cash flow before interest and taxes covers all fixed financing charges (interest plus loan repayment). A ratio of more than 1 is considered safe.
$$\text{Fixed Charges Coverage Ratio} = \frac{\text{EBIT} + \text{Depreciation}}{\text{Interest} + \text{Repayment of Loan}}$$
### Related: Debt Service Coverage Ratio (DSCR)
Earnings available for debt service are computed as:
> Net profit (EAT) + non-cash operating expenses (depreciation and other amortisations) + Interest + other adjustments such as loss on sale of fixed assets.
Note: Fund from operations (or cash from operations) before interest and taxes may also be used as per the requirement.
### Doubt Busters (terminology)
- EBIT = PBIT (Profit before interest and taxes); EAT = PAT (Profit after taxes); EBT = PBT (Profit before taxes).
- Ratios are computed based on the requirement and availability of information and may deviate from the original formula — state your assumptions if you deviate.
- The numerator must correspond to the denominator and vice-versa.