Coverage ratios exist in various forms and can be used to assist in identifying organizations in potentially harmful financial situations. (Note: low ratios do not always indicate that a company is in financial danger.)
Many elements go into creating these financial ratios, and a deeper dig into a company's financial accounts is typically necessary to determine a business's health.
Net income, interest expenditure, debt outstanding, company's cash balance, and total assets are just a few examples of financial statement components to scrutinize. To determine the financial health of a firm, take a look at liquidity and solvency ratios, which examine a company's capacity to pay short-term debt and convert assets into cash.
Investors can utilize coverage ratios in one of two ways. For starters, they may monitor changes in the company's debt condition over time. When the debt-service coverage ratio is within the acceptable range, it is a good idea to look at the company's recent history. If the ratio has been progressively falling, it may only be a matter of time until it goes below the suggested level.
Coverage ratios are also useful when comparing one firm to its competitors. Evaluating similar firms is critical since a acceptable coverage ratio in one area may be considered dangerous in another. If the company you're considering appears to be out of step with significant rivals, this is usually a warning indicator.
While comparing coverage ratios of firms in the same industry or sector can give vital insights into their respective financial circumstances, doing so across companies in other sectors is less beneficial because it may be like comparing apples to oranges.
What exactly is a cash coverage ratio?
The cash coverage ratio is a metric that measures a company's capacity to pay down its liabilities with its existing cash. It is used to assess a company's liquidity. Only cash and cash equivalents are included in the cash coverage ratio. Accounts receivable and inventories are not included.
Creditors like to utilize a cash coverage ratio since it reveals a company's capacity to pay off debt promptly. Other formulas that take into account assets or inventories may not always provide an accurate projection of payment ability. Long-term assets or inventories may take longer to sell, making it harder to use the proceeds to settle obligations. Other ways for assessing a company's financial health include the interest coverage ratio, debt service coverage ratio, and asset coverage ratio.
Advantages of Using the Cash Coverage Ratio
The cash coverage ratio is one approach organizations can use to calculate their assets.
The cash coverage ratio has the following advantages:
Most creditors utilize the cash coverage ratio to establish credit eligibility and financial standing. It gives customers a company's capacity to pay off present financial obligations. Because certain creditors have particular conditions to qualify for a loan, this might assist brands in determining if they are suitable.
Create revenue possibilities
Identifying the cash coverage ratio assists organizations in finding revenue opportunities. Shareholders can also use this ratio to forecast future financial performance.
Identify the company's liquidity
The cash coverage ratio is essential for identifying a brand's capacity to pay off its obligations and how soon it can do so.
Some brands may utilize the cash coverage ratio to attract investors. This ratio may also determine the company's financial requirements, which can be useful when approaching investors. More investors may be ready to invest if the firm can demonstrate that it can service its debt.
How to Calculate the Cash Coverage Ratio
The cash coverage ratio may be calculated as follows:
Compute all cash and cash equivalents
A balance sheet and income statement will typically include information on cash and cash equivalents. Depending on your company's accounting methods, these numbers may display together or individually. Cash equivalents are assets or investments that may be converted to cash rapidly, generally in 90 days or less. This might include treasury bills, money market funds, or government bonds.
Subtract the entire current liabilities of the firm
Divide the total cash and cash equivalents by the total current obligations (including any interest expense). This yields the cash coverage ratio. Include the company's present obligations rather than its long-term liabilities. These figures should be visible on the balance sheet, and most businesses disclose them separately from other debt. Current obligations may include accounts payable, sales taxes payable, or accrued costs. It would also cover short-term loans.
Examine the computation
The ratio might help you estimate your company's capacity to repay loans. A cash coverage ratio of one indicates that the company has just enough cash to meet its present liabilities.
If the ratio is greater than one, it indicates that the company has sufficient finances to pay off its present obligations. A ratio of less than one indicates that it does not have enough cash or cash equivalents to pay down current debt.
A ratio smaller than one may also be converted into a percentage by multiplying by 100, which can assist a brand in determining how close they are to an even cash coverage ratio. This may be crucial when you apply methods to increase your cash coverage ratio. For example, a brand with a cash coverage ratio of 0.75 may cover 75% of its debt.
Improve your ratio
Many companies utilize the cash coverage ratio to enhance their finances. A ratio of one might reflect financial soundness. A ratio of less than one may inspire firms to investigate measures to boost income or reduce overall debt. While a ratio of more than one implies that the firm has the finances to pay its obligations, most businesses do not maintain a much greater than equal ratio.
Example of determining the cash coverage ratio
A company needs to evaluate its cash coverage ratio as they explore financing alternatives for entering a new market. The balance sheet provides the required information, including their cash and cash equivalent funds. Here is an example of how to calculate the cash coverage ratio:
The corporation calculates that it has $180,000 in cash and $20,000 in cash equivalents. Then, to get their total cash available, they perform the following calculation:
Cash + Cash Equivalent = Total Cash Available
$180,000 + $20,000 = $200,000
This computation provides them with the entire amount of cash accessible. Then, using the balance sheet, they determine the current obligations and divide the first amount. Their liabilities total $180,000. They calculate the cash coverage ratio as follows:
Total Cash Available/Current Liabilities = Cash Coverage Ratio
$200,000/$180,000 = 1.11
Using this formula, the cash coverage ratio is 1.11. This signifies that they now have enough money to pay off all debt obligations, which is good for potential lenders.
Enhancements to the Cash Coverage Ratio
There may be extra non-cash things to deduct in the numerator of the calculation. For example, there might have been significant expenses in a period to enhance reserves for sales allowances, product returns, bad debts, or inventory obsolescence.
If these non-cash items are significant, include them in the computation. Also, the interest expenditure in the denominator should only comprise the actual interest expenses to be paid; if there is a premium or discount to the amount being paid, it is not a cash payment and should not be included in the denominator.