What Is a Cash Coverage Ratio?
The cash coverage ratio formula is a way for accountants and business owners to determine if a business has adequate funds to pay for interest and day-to-day operating costs. It will also help determine if the business is able to make a profit or must spend all its money to pay down debt. The ratio itself is easy to calculate and is done in a few steps. Answers higher than 1 are better, and answers lower than 1 typically show the business will be going bankrupt soon.
Cash coverage ratio is a formula that takes three numbers: earnings before interest and taxes (EBIT), non-cash expenses such as depreciation, and the interest expense. The interest expense should only include money being paid, and not discounts or premiums. Most bookkeepers, accountants and accounting software can figure out these numbers if they are not known offhand. The number derived from the formula shows how much money a company has compared to its debt.
The formula starts by taking the EBIT and adding it to the non-cash expenses. If the EBIT is $300 U.S. Dollars (USD) and the non-cash expense is $100 USD, the total is $400 USD. This number is then divided by the interest expense. If the interest expense is $200 USD, for example, then the calculation is 400/200. This leaves 2, making a ratio of 2:1.
The leftover number represents how much money the company has to pay down its expenses. In the above example, the company has $2 USD for every $1 USD of debt. The company will be able to pay its debt and have a profit left after all the expenses.
If the number is less than 1, this leaves the company in a bad place. This means the company cannot pay all of its debts. A number less than 1 is seen as an indicator that the business will go bankrupt, typically within a few years. The higher the number, the better the company is doing.
Cash coverage ratio is used as an indicator to show whether any given business is able to meet its financial obligations. It uses the actual costs and expenses of the business, so it is considered accurate in terms of showing the success of a company. If a company uses expense estimates, the cash coverage ratio can still be accurate, but only if the estimates are correct.
This is the metric that all boards of directors should have drilled into their heads. Boards tend to go nuts at times, wanting to invest in things the company can't afford based on the notion that money will magically show up to cover all of a company's obligations.
That sounds far fetched, but that principal seems to be in play quite a bit.
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