This checklist defines what debt cover is and how it is used. It is also sometimes referred to as “times debt covered.”
Debt cover is defined as the ratio of a company’s total assets to its debt. It helps to assess the amount of cash flow available to meet annual interest and principal payments on a debt, including sinking fund payments. Should a company be wound up, the ratio would indicate by how much the shareholders’ redemption value and prior charges and any future capital charges would be covered by the assets. This useful metric indicates how easily a company can meet its interest and principal payments from its revenues.
Debt cover is calculated by dividing a company’s operating income (either EBIT or EBITDA) by the debt expenses, i.e. the interest charges. Banks typically use debt cover as an indicator for determining economic risk when making loans. Typically, a bank looks for a ratio of between 1.15× and 1.35× (net operating income divided by annual debt service) to be satisfied that there is sufficient cash flow available on an ongoing basis to repay the loan instalments.
However, the debt cover may sometimes be less than 1× for a loan. This does not necessarily mean that the company is at risk of default, although it is certainly an indicator of potential financial problems ahead as it means there is, at the time of calculation, a negative cash flow. For example, a ratio of 0.9× indicates that there is only enough net operating income to cover 90% of annual debt payments, and the company would therefore have to repay borrowings using cash or by taking out a further loan. Usually banks are unlikely to lend where there is negative cash flow, but they may decide to take the risk if the company can clearly demonstrate that this is a temporary blip.
Over a period of time the debt cover should improve as a company pays down its debts and, generally speaking, as with other metrics that measure credit risk, the higher the ratio the better as it means a lower risk of capital loss.
Debt cover is a useful measure of financial strength. It can indicate not only what the debt cover was at a particular point in time, but also how much it has changed since it was last evaluated. It is thus a way of assessing a company’s financial quality and associated risk levels.
Debt cover should never be used as the sole metric test of a company’s financial soundness. Only if you have access to the current books can you know if there are otherwise unknown changes in a company’s financial situation. Use other metrics in conjunction, such as the interest coverage ratio, to gain a fuller picture.