Coverage ratio is a number that refers to a company’s ability to meet its obligations. Specifically, the ratio involves dividing the company’s income or cash flow with a certain expense and this will determine the company’s financial solvency.
Some common ratios include fixed-charge coverage ratio, debt service coverage ratio, times interest earned and interest coverage ratio. You can, however, regard many measures of a company’s ability to cover its debts as coverage ratios.
The magical number that is to be achieved and indicates that a company’s financial health is intact is 1.0. Any ratio that is equal to or greater than 1.0 is a telltale sign that company’s earnings and cash flow are able to meet all of its obligations. If you find companies that have ratios that are below 1.0 then that will tell you that the company may or may not be able to fulfill its financial responsibilities.
Coverage ratios do give a measure of a company’s ability to meet expenses and is one indicator of a company’s overall financial health. However, the ratios only include the company’s current earnings and the company’s current expenses. This does not necessarily give you the most complete picture. The information will only be able to tell you if the company is able to meet its short-term obligations.
The SEC requires that public companies publicize their procedures for calculating their ratios and other financial measures. It should be known that coverage ratio standards differ dependent upon which industry the company represents.
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