Coverage ratios are designed to relate the financial charges of a firm to its ability to service, or cover, them. Bond rating services, such as Moody's Investors Service and Standard & Poor's, make extensive use of these ratios. One of the most traditional of the coverage ratios is the interest coverage ratio, or times interest earned. This ratio is simply the ratio of earnings before interest and taxes for a particular reporting period to the amount of interest charges for the period; that is,
Earnings before interest and taxes (EBIT)
For Aldine, in fiscal-year 20X2 this ratio is
$400,000 / $85,000 = 4.71
This ratio serves as one measure of the firm's ability to meet its interest payments and thus avoid bankruptcy. In general, the higher the ratio, the greater the likelihood that the company could cover its interest payments without difficulty. It also sheds some light on the firm's capacity to take on new debt. With an industry median average of 4.0, Aldine's ability to cover annual interest 4.71 times with operating income (EBIT) appears to provide a good margin of safety.
A broader type of analysis would evaluate the ability of the firm to cover all charges of a fixed nature. In addition to interest payments, we could include principal payments on debt obligations, preferred stock dividends, lease payments, and possibly even certain essential capital expenditures. As we will see in Chapter 16, an analysis of this type is a far more realistic gauge than a simple interest coverage ratio in determining whether a firm has the ability to meet its long-term obligations.
In assessing the financial risk of a firm, then, the financial analyst should first compute debt ratios as a rough measure of financial risk. Depending on the payment schedule of the debt and the average interest rate, debt ratios may or may not give an accurate picture of the firm's ability to meet its financial obligations. Therefore we augment debt ratios with an analysis of coverage ratios. Additionally, we realize that interest and principal payments are not really met out of earnings per se, but out of cash. Therefore it is also necessary to analyze the cashflow ability of the firm to service debt (and other financial charges as well). The topics addressed in the following chapter, as well as Chapter 16, will aid us in that task.