COVERAGE RATIOS
Measure an ability of a company to meet its financial obligations

RATIO

FORMULA

APPLICABILITY

Debt Ratio

Total Liabilities

÷

Total Assets

This ratio shows the percentage of assets financed by creditors and is often used to evaluate the company’s dependence on debt.

Important

Notes!

When evaluating debt ratios, it is important to remember that 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.

Debt to Equity Ratio

Total Liabilities

÷

Equity

This ratio shows the company’s financial stability and dependence on creditors.

Important

Notes!

Some advantages of debt to equity ratio are easy calculation and sufficiency of obtained results. That’s why it is widely used for investment purposes. However, the debt to equity ratio can be distorted when a company has a substantial amount of operating liabilities in its total liabilities structure.

Capitalization Ratio

Long-term Liabilities

÷

Long-term Liabilities + Shareholder’s Equity

Shows what portion of a company’s capital (debt and equity) is represented by debt.

Important

Notes!

When evaluating capitalization ratios, it is important to consider that a company with a high capitalization ratio may have hard times repaying debt or obtaining additional loans. On the other hand, a company with a very low capitalization ratio may not be risky, but may have conservative management (which is not using opportunities for the company’s growth through long-term borrowings) and therefore provides lower earnings to its shareholders.

Times Interest Earned Ratio

Earnings before Interest
and Taxes (EBIT)

÷

Interest Expenses

Measures a company's ability to meet its debt obligations.

Important

Notes!

• Generally and without consideration of other ratios, a company with a high times interest earned ratio is financially strong. Lower levels of this ratio may indicate that the company’s earnings (EBIT) are not sufficient to pay the company’s debt obligations. However, in practice, when this ratio is very high, it could also mean that the company underutilizes debt.
• The numerator in the times interest earned formula should include capitalized interest (i.e., interest incurred, but not expensed because it was included in the cost of constructed fixed asset).

Cash Debt Coverage Ratio

Net Cash Provided by
Operating Activities

÷

Average Total Liabilities

Shows how much of company’s total liabilities can be covered (paid) with net cash from operating activities.

Important

Notes!

Cash debt coverage ratio of 1 is considered to be reasonably good evidence of a company’s financial stability. In general, a high level of this ratio is considered to be a favorable by creditors and investors. Contrary, a low cash debt coverage debt ratio implies the company may have financial stability problems in the nearest future because it will not be able to sustain debt payments.

Fixed Charge Coverage Ratio

(EBIT + Fixed Charge before Tax)

÷

(Fixed Charge before Tax + Interest)

Measures the ability of a company to meet its fixed charges (e.g., lease payments).

Important

Notes!

• Similar to the times interest earned ratio, the higher the fixed charge coverage ratio, the better.
• Fixed charges may vary and can include a portion of operating lease payments, depreciation, amortization, and debt principal payments. Thus, it is important to understand what is included in fixed charges when analyzing fixed charge coverage ratios to ensure comparability of results.