Cash Coverage Ratio

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What is the Cash Coverage Ratio?

The cash coverage ratio is a financial indicator used to assess a company's capacity to meet its interest costs out of its available cash. It goes by the names cash flow coverage ratio and cash interest coverage ratio as well. It serves as a gauge of a business's liquidity, soundness, and margin of safety with regard to paying off debt.

Why Cash Coverage Ratio is important?

The significance of the cash coverage ratio is in its ability to indicate how successfully a business can make enough money from its activities to pay its interest. Regardless of the company's performance or profitability, interest payments are a fixed expense that must be made. 

A corporation may face default or bankruptcy if its cash coverage ratio is low, indicating that it does not have enough cash on hand to cover its interest expenses. Conversely, a high cash coverage ratio indicates that the business has enough cash on hand to meet its interest expenses and may even have extra to allocate to debt reduction, dividend payments, and expansion prospects.

Formula for Cash Coverage Ratio

The formula for the cash coverage ratio is:

Cash Coverage Ratio = (Earnings Before Interest and Taxes + Non-Cash Expenses) / Interest Expense

Where:

• Earnings Before Interest and Taxes (EBIT) is the income of the company before deducting interest and taxes. It is also known as operating income or operating profit.
• Non-cash expenses are expenses that do not affect the cash flow of the company, such as depreciation and amortization. They are added back to EBIT because they reduce the net income but not the cash flow of the company.
• Interest Expense is the amount of interest that the company pays on its debt in a given period.

The formula can be derived from the income statement of the company as follows:

Net Income = EBIT - Interest Expense - Taxes
Net Income + Interest Expense + Taxes = EBIT
Net Income + Interest Expense + Taxes + Non-Cash Expenses = EBIT + Non-Cash Expenses
(Net Income + Interest Expense + Taxes + Non-Cash Expenses) / Interest Expense = (EBIT + Non-Cash Expenses) / Interest Expense
Cash Coverage Ratio = (EBIT + Non-Cash Expenses) / Interest Expense

How to calculate the cash coverage ratio?

The cash coverage ratio is calculated by adding the earnings before interest and taxes (EBIT) and the non-cash expenses (such as depreciation and amortization) and dividing the sum by the interest expense.

The non-cash expenses can be retrieved from the cash flow statement or by adding the depreciation and amortization expenses back to the EBIT. The EBIT is shown on the income statement. You can also find the interest expense by multiplying the total debt by the average interest rate or by looking at the income statement.

Examples of cash coverage ratio

Let's look at some examples of how to calculate the cash coverage ratio for different companies.

Company A 

has an EBIT of $500,000, depreciation and amortization of $200,000, and interest expense of $100,000. Its cash coverage ratio is:

Cash Coverage Ratio = ($500,000 + $200,000) / $100,000
Cash Coverage Ratio = 7

This indicates that Company A's operating cash flow is sufficient to meet its interest payments.

Company B 

has an EBIT of $300,000, depreciation and amortization of $100,000, and interest expense of $150,000. Its cash coverage ratio is:

Cash Coverage Ratio = ($300,000 + $100,000) / $150,000
Cash Coverage Ratio = 2.67

This indicates that Company B's cash flow from activities can pay for its interest payments, but not by much.

Company C 

has an EBIT of $100,000, depreciation and amortization of $50,000, and interest expense of $200,000. Its cash coverage ratio is:

Cash Coverage Ratio = ($100,000 + $50,000) / $200,000
Cash Coverage Ratio = 0.75

This indicates that Company C may experience financial issues as a result of its inability to meet its interest payments with operating cash flow.

Limitations of cash coverage ratio

The cash coverage ratio is a useful indicator of a company's ability to service its debt obligations, but it also has some limitations that should be considered when using it for financial analysis.

• The principal repayments of debt, which are a component of the debt service obligations, are not included in the cash coverage ratio. If a business has a significant amount of debt that is due to mature soon, even with a good cash coverage ratio, it may still find it difficult to pay back the principal.
• The seasonality and volatility of cash flows are not taken into consideration by the cash coverage ratio. Based on its typical or annual cash flows, a company may have a high cash coverage ratio; nevertheless, during times of low or negative cash flows, the company may struggle to make its interest payments.
• The sustainability or quality of the cash flows are not reflected in the cash coverage ratio. Due to one-time or irregular cash inflows like asset sales or tax refunds, which might not be available in the future, a corporation may have a high cash coverage ratio.
• Using cash for debt service has opportunity costs that are not taken into account by the cash coverage ratio. If a corporation utilizes the majority of its cash for interest payments, it may have a high cash coverage ratio but miss out on potential growth opportunities or profitable investment alternatives.

FAQ

There is no definitive answer to what constitutes a good cash coverage ratio, as it may vary depending on the industry, the type of debt, and the expectations of the lenders. However, a general rule of thumb is that a ratio of 1 or higher is considered adequate, meaning that the company can cover its interest expenses with its cash flow. A ratio of less than 1 is considered inadequate, meaning that the company cannot cover its interest expenses with its cash flow.

A company can improve its cash coverage ratio by increasing its EBIT, reducing its non-cash expenses, or decreasing its interest expense. For example, a company can increase its EBIT by increasing its sales, reducing its costs, or improving its efficiency. A company can reduce its non-cash expenses by using less depreciation methods or amortizing its assets over a longer period. A company can decrease its interest expense by refinancing its debt at a lower interest rate or paying off some of its debt.