Coverage ratios are financial metrics used to assess a company’s ability to meet its financial obligations, such as debt payments or dividend payouts.
Primary Implication
The lower the coverage ratios for a business, the more it uses debt and other liabilities to finance its assets. Should the business experience a profit downturn, it isn’t likely to pay its debts. Any debt repayment failure puts the business at an increased risk of being liquidated by its creditors.
Overview
When shareholders own a majority of the assets, the company is said to be less leveraged. When creditors own the majority of the assets, the company is considered highly leveraged, resulting in a riskier and less sustainable capital structure.
Coverage Ratios are comparisons designed to measure a company’s ability to pay its liabilities by analyzing its ability to service its debt and other obligations. Below are the three most commonly used coverage ratios:
- Financial Leverage Ratio
- Fixed Charge Coverage
- Debt Service Coverage
On the surface, Coverage Ratios may seem like Liquidity and Solvency Ratios, but there is a distinct difference. These ratios measure how easily a business can afford to meet the interest payments associated with its debt.
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