Definition of Coverage Ratio
Coverage ratio measures the company’s ability to absorb a shock of payments such as interest and dividends. Coverage ratios are normally calculated for interests and it is called as interest coverage ratio. The interest coverage ratio measures the company’s ability to pay interest out of its earnings before interest and taxes. The higher the interest coverage ratio is, the more safe is the debtholders’ interest payments will be.
Assume a company has a total debt of $50 million that pays interest of 8% i.e. $4 million ($50 million x 8%). The company’s EBIT is $13 million. Calculate the interest coverage ratio.
Interest coverage ratio = $13 million / $4 million = 3.25 times
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