Financial Education

Coverage ratios indicate whether a company has sufficient resources to meet its contractual obligations. As such, they are a form of solvency ratio. Like the other solvency ratios, there are various ways to measure this ability.

• (Earnings before interest and taxes)/(Interest expense) measures whether a company earns enough to pay the interest on its debt.
• (Cash flow from operations + Cash interest paid + Cash taxes paid)/(Cash interest paid) expresses whether the company can meet its interest payments on a cash basis. This can be important if the company has significant non-cash expenses (like depreciation) or non-cash interest expense (such as zero-coupon bonds.)
• (EBIT + Rent)/(Interest expense + Rent) measures whether the company can meet both its interest expense and contractual operating lease expenses.
• (EBIT)/(Interest expense + Principal payments) indicates whether the firm generates enough income to pay both the interest expense and required principal repayments on its existing debt.

As an example, consider the third ratio for Plantronics. We can find EBIT right on the income statement. The company does not break out its interest expense, but instead reports a net interest income (interest income less interest expense). In this case, since the interest income is more than sufficient to cover interest expense we will simply assume that interest expense is zero. The income statement also does not break out rent expense. For that we have to turn to the footnotes – Specifically note 21 on page 104 of the annual report:

Total rent expense for operating leases was approximately $3.0 million, $3.4 million, and $4.6 million in fiscal 2004, 2005, and 2006, respectively.

For the purposes of the ratio, we will use the $4.6 million spent in 2006, as this is the period that corresponds to the other information.

EBIT (Operating income)	110,362
Rent expense	4,600
Interest expense	0
(EBIT + Rent)/(Interest expense + Rent)	25x

This shows that Plantronics’ operating income is 25 times as much as would be needed to merely meet the company’s contractual obligations.

For more information, see all articles on: Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Ratio Analysis, Security Selection

See also:

Solvency Ratios

Cash Flow Ratios

Analyzing Asset Retirement Obligations

Debt Covenants

Asset Retirement Obligations – US Cellular Case Study