Coverage Ratio: Definition, Types, Formulas, and Examples

What is a coverage ratio?

A coverage ratio measures a company’s ability to meet its financial obligations—primarily interest and debt payments—using its earnings or assets. These ratios help investors, creditors, and analysts assess long-term solvency and the risk of default.

Key points:
* A high coverage ratio suggests a firm can comfortably meet its future interest and debt obligations.
* A low coverage ratio signals potential difficulty servicing debt, though context and industry norms matter.
* Compare coverage ratios only among similar companies or within the same industry.

Common coverage ratios and formulas

Interest Coverage Ratio (Times Interest Earned)

Measures the ability to pay interest expenses from operating earnings.
Formula: Interest Coverage = EBIT / Interest Expense
Interpretation: A ratio of 2 or higher is often considered satisfactory, but suitable levels vary by industry.

Debt Service Coverage Ratio (DSCR)

Measures ability to cover total debt service (principal + interest) from operating income.
Formula: DSCR = Net Operating Income / Total Debt Service
Interpretation: A DSCR ≥ 1 indicates sufficient earnings to meet debt obligations. Ratios close to 1 leave little margin for error.

Asset Coverage Ratio

Assesses how much of a company’s assets are available to cover debt.
Formula: Asset Coverage = (Total Assets − Short-Term Liabilities) / Total Debt
Interpretation: Rule-of-thumb targets vary—utilities often aim for ≥ 1.5, industrial firms ≥ 2.

Other coverage-related ratios (brief)

• Fixed-charge coverage ratio — ability to cover fixed costs (debt, leases) from earnings.
• Loan Life Coverage Ratio (LLCR) — NPV of cash available for debt repayment divided by outstanding debt; used in project finance.
• EBITDA-to-interest coverage — EBITDA divided by interest expense; evaluates capacity to cover interest from cash earnings.
• Preferred dividend coverage — company’s ability to pay required preferred dividends.
• Liquidity Coverage Ratio (LCR) — for financial institutions: high-quality liquid assets relative to short-term outflows.
• Capital loss coverage ratio — measures support for losses when nonperforming assets are liquidated.

Example: Cedar Valley Brewing

Assumptions (quarterly):
* EBIT = $300,000
Interest expense = $50,000
Net operating income = $200,000
* Total debt service (principal + interest) = $190,000

Calculations:
* Interest coverage = $300,000 / $50,000 = 6.0 (comfortably covers interest)
* DSCR = $200,000 / $190,000 ≈ 1.05 (covers debt service but with little buffer)

Takeaway: A firm can look strong by interest coverage yet still be risky once principal repayments are considered.

How to use coverage ratios

• Use them to screen for solvency risks and to compare peers within the same industry.
• Investigate trends over time—declining coverage ratios can signal weakening financial health.
• Combine coverage ratios with other financial statement analysis for a fuller picture (cash flow, leverage, liquidity).

What is a “good” coverage ratio?

There’s no universal cutoff. Common guidance:
* Interest coverage of 2× or more is often acceptable.
* DSCR of 1.0 or above means obligations are covered; higher is safer.
But acceptable levels depend on industry capital intensity, business stability, and the firm’s cash flow volatility.

Conclusion

Coverage ratios are essential tools for assessing a company’s ability to service debt and meet financial obligations. Use the appropriate ratio for the question at hand (interest payments, total debt service, or asset backing), compare like with like, and always supplement ratio analysis with detailed financial statement review.