## Coverage Ratios

Coverage ratios answer a critical question for long-term creditors and preference shareholders: does the firm generate sufficient earnings to service its fixed financial obligations — interest, principal repayments, and preference dividends?

### 1. Debt Service Coverage Ratio (DSCR)

Formula: DSCR = Earnings for Debt Service / (Interest + Instalment) — in Times

Numerator — Earnings for Debt Service:

Net Profit After Tax (PAT)
(+) Interest on Debt Funds
(+) Non-Cash Operating Expenses (depreciation, amortisation)
(+) Non-Operating Adjustments (loss on sale of fixed assets, etc.)

Denominator:

Interest on debt
(+) Principal repayment instalment

Ideal: 2 to 3 times — this is the primary metric used by banks to appraise term loan proposals.

Why add back depreciation? Depreciation is a non-cash charge; the money is still in the business and available for debt repayment.

### 2. Interest Coverage Ratio (ICR) / Times Interest Earned

Formula: ICR = EBIT / Interest — in Times

EBIT = Earnings Before Interest and Tax
Must be > 1. A ratio < 1 means operating earnings cannot cover even the interest — a severe financial distress signal.

### 3. Preference Dividend Coverage Ratio

Formula: = EAT / Preference Dividend — in Times

Should be > 1.
Uses EAT (after-tax profit) because preference dividend is paid from post-tax income.

### Hierarchy of the Three Ratios

ICR covers only interest. DSCR covers interest + principal, using cash-adjusted earnings — it is therefore the most conservative and comprehensive measure of debt-servicing capacity.

Worked example

### Example 1

Example 1 – Excellence Ltd.: ISCR and DSCR (from Question 9)

Given (₹ in lakhs): PAT = 480; Depreciation = 155; Tax = 125; Interest on Term Loans = 162; Repayment Instalment = 178

Interest Coverage Ratio (ISCR):

EBIT = PAT + Tax + Interest = 480 + 125 + 162 = ₹767 lakhs

ISCR = EBIT / Interest = 767 / 162 = 4.73 times ✓ (comfortably above 1)

Debt Service Coverage Ratio (DSCR):

Earnings for Debt Service = PAT + Interest + Depreciation = 480 + 162 + 155 = ₹797 lakhs

DSCR = 797 / (Interest + Instalment) = 797 / (162 + 178) = 797 / 340 = 2.34 times ✓

Interpretation: The company generates ₹2.34 of adjusted cash earnings for every ₹1 of debt service obligation — within the ideal 2–3 range, supporting a positive loan appraisal.

### Example 2

Example 2 – FLOW Ltd.: Fixed Charge Coverage (from Question 8)

Given (₹ lakhs): EBIT = 2.99; Interest = 0.47; Preference Dividend = 0.20; Tax rate = 50%

Fixed charges include both interest and preference dividend. Since preference dividend is paid from after-tax profits, it must be grossed up for tax to make it comparable with EBIT:

Grossed-up Preference Dividend = 0.20 / (1 − 0.50) = ₹0.40 lakhs

Total Fixed Charge = 0.47 + 0.40 = ₹0.87 lakhs

Fixed Charge Coverage = EBIT / Total Fixed Charge = 2.99 / 0.87 = 3.44 times

The grossing-up step is essential: interest is tax-deductible (pre-tax cost) but preference dividend is not (post-tax cost), so they cannot be directly summed.

⚠️ Common exam mistakes

Forgetting to add back depreciation in the DSCR numerator — it is non-cash and is available for debt repayment.
Using EBT instead of EBIT for Interest Coverage Ratio — EBT already deducts interest, making the ratio circular and meaningless.
Not grossing up preference dividend for tax when computing Fixed Charge Coverage Ratio.
Including current maturities of long-term debt (principal repayment) in the ICR denominator — ICR covers only interest; DSCR covers interest + principal.
Confusing DSCR with ICR: DSCR is a cash-flow-based ratio; ICR uses accrual EBIT.

Reference:

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