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What Is Coverage Ratio and How Calculating It Helps?

Company research is an essential element of making stock trading decisions. Helping in this research are calculations such as the coverage ratio.    

What Is Coverage Ratio and How Calculating It Helps? 

Coverage ratio is the measurement of a company’s capability to meet its financial obligations such as dividends and interest payments as well as its debt. It significantly helps in company research and is something you rely on along with advanced trading software.  

A higher coverage ratio makes it easier for the company to fulfil its financial obligations. Investors and analysts study the historical trend of a stock’s coverage ratios to detect whether the financial position of a company has changed.    

How Crucial Is the Coverage Ratio?

  • Coverage ratios help detect companies that could be heading for troubled financial waters. 

Calculating Coverage Ratio

  • Interest coverage ratio/Interest earned ratio

It measures a company’s ability to pay the interest of its debt.

It is calculated as: 

EBIT / Interest Expense

EBIT refers to earnings before interest and taxes. A satisfactory interest coverage ratio is usually 2 or more.  

  • Debt Service Coverage Ratio (DSCR)

It measures the ability of a company to pay all its near-term debt principal plus interest payments 

It is calculated as:

Net operating income / Total Debt Service

A figure of 1 or above indicates the company’s earnings are sufficient to cover all debt obligations

  • Asset Coverage Ratio

It measures a company’s balance sheet assets.

It is calculated as:

Total Assets – Short-term Liabilities / Total Debt

Total assets are buildings, machinery, inventory, land and other such tangible assets

A 1.5 ratio is satisfactory for utilities, while a ratio of 2 is satisfactory for industrials. The coverage ratio is one of the many indicators that can help stock traders gauge the worth of a business. It helps while trading stocks online.  

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