Profitability and Coverage Analysis
3. Financial analysis of coverage
Coverage of a company is its ability to meet its financial obligations. In other words, coverage shows the ability to “cover” the company’s short and long-term liabilities.
Based on the definition above, coverage is a relationship between profits (e.g., operating profit, net profit, EBIT) or assets and corresponding obligations (e.g., interest expenses).
A coverage ratio of 1 or greater is said to represent a company’s ability to fulfill its obligations; a coverage ratio of less than 1 may indicate that the company is unable to pay (cover) its expenses or liabilities.
It is important to remember that a higher coverage ratio may not always be better. In addition, coverage ratio benchmarks are different in different industries. When comparing coverage ratios, the average within an industry should be taken into account.
The most common coverage ratios are as follows:
- Debt ratio
- Debt to equity ratio
- Capitalization ratio
- Times interest earned
- Cash debt coverage
- Fixed charge coverage ratio
3.1. Debt ratio
Debt ratio is the relationship between total liabilities and total assets. This ratio shows the percentage of assets financed by creditors and is often used to evaluate the company’s dependence on debt. This ratio is calculated by dividing total liabilities by total assets.
The higher the debt ratio is, the riskier the company is, and on the contrary, the lower the debt ratio is, the less risky the company is.
Debt Ratio Formula
Debt ratio is calculated by dividing total liabilities (current and non-current liabilities) by total assets:
Debt Ratio = |
Total Liabilities |
Total Assets |
Debt Ratio Example
In our example of Friends Company, to determine its debt ratio, we will use the balance sheet for 20X9 available at the end of this tutorial. The debt ratio for fiscal year 20X9 can be determined as follows:
Debt Ratio = |
$5,300 + $3,220 |
= 0.32 (rounded) |
$26,870 |
Debt ratio of 0.32 (or 32%) means that only 32% of the company's assets are financed with debts.
Important Notes
- When evaluating debt ratios, it is important to remember that a company’s liabilities normally include operational liabilities (e.g., accounts payable and accrued expenses), which don’t represent debt similar to a long-term note payable. So, if you do not take this fact into account, your interpretation of debt ratios can be distorted.
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