Debt Coverage Ratio
The term debt coverage ratio refers to a measure that allows the investor-analyst to understand the ability of a company to meet its near term debt obligations. The debt coverage ratio is found by taking operating earnings and dividing it by interest expense plus principal payments coming due in the same timeframe.
Debt Coverage Ratio = Operating Income / (Interest Expense + Principal Payments / (1- Tax Rate))
- Operating income is obtained from the company's income statement and is equal to earnings before interest and taxes (EBIT).
- The denominator of this ratio includes both interest expense and principal payments adjusted for taxes.
Capital structure and solvency measures allow the investor-analyst to understand the company's ability to remain in business in the long term. This is usually assessed by examining the relationship between debt, equity and the proportions of different types of stock. Solvency is the ability to continue operating, which oftentimes depends on cash flow. One of the ways to understand the overall solvency position of a company is by calculating their debt coverage ratio.
The debt coverage ratio provides the investor-analyst with information in terms of the ability of a company to repay its debt. This metric compares earnings before interest and taxes (EBIT) to both the interest expense paid by the company as well any scheduled principal payments coming due over the same timeframe. If the company is generating enough cash to make its debt obligations, this ratio will be 1.0 or greater.
Company ABC's CFO wants to be sure the company's earnings are sufficient to cover its debt obligations before releasing funding of employee's incentive compensation for the year. She asked her analytical team to calculate the company's debt coverage ratio using their yearend forecast. The information found on the forecast included operating earnings of $1,287,000,000, interest expense of $592,000,000, and principal payments coming due of $296,000,000. The company's debt coverage ratio would then be:
= $1,287,000,000 / ($592,000,000 + ($296,000,000 / (1 - 0.21))= $1,287,000,000 / ($592,000,000 + $374,684,000)= $1,287,000,000 / ($592,000,000 + $374,684,000)= $1,287,000,000 / $966,684,000, or 1.33
Since the debt coverage ratio was greater than 1.0, the CFO approved funding of the employee incentive compensation program.