The coverage ratios are similar to liquidity ratios in that they describe the quantity of funds available to “cover” certain expenses. We will examine two very similar ratios that describe the firm’s ability to meet its interest payment obligations. In both cases, higher ratios are desirable to a degree. However, if they are too high, it may indicate that the firm is under-utilizing its debt capacity, and therefore not maximizing shareholder wealth.
The Times Interest Earned Ratio
The times interest earned ratio measures the ability of the firm to pay its interest obligations by comparing earnings before interest and taxes (EBIT) to interest expense:
Times Interest Earned = ————————-
For ROYAL BALI CEMERLANG in 2004 the times interest earned ratio is:
Times Interest Earned = ——————– = 1.97 times
Notice that this ratio has declined rather precipitously from 3.35 in 2003.
The Cash Coverage Ratio
EBIT does not really reflect the cash that is available to pay the firm’s interest expense. That is because a non-cash expense (depreciation) has been subtracted in the calculation of EBIT. To correct for this deficiency, some analysts like to use the cash coverage ratio instead of times interest earned. The cash coverage ratio is calculated as:
EBIT + Non-Cash Expenses
Cash Coverage Ratio = ——————————————-
The calculation for ROYAL BALI CEMERLANG in 2004 is:
149.70 + 20.00
Cash Coverage Ratio = ———————– = 2.23 times
Note that the cash coverage ratio will always be higher than the times interest earned ratio. The difference depends on the amount of depreciation expense, and therefore the investment and age of fixed assets. In 2003, the ratio was 3.65.