Earnings Coverage Ratios
Earnings coverage ratios are related to financial leverage because one of the key issues related to debt is the fact that a fixed payment (interest) must be made on a regular basis. The more debt a firm has, the bigger its interest obligation becomes. As the company’s interest obligation becomes larger, the risk becomes greater that the company will not be able to cover its interest payments and will default on the debt.
While capital structure ratios such as those above can provide information on how much of a company’s financing comes from debt, they cannot provide information on whether the company will have enough earnings to service the debt. Therefore, earnings coverage ratios are used to focus on the company’s earning power, because the company’s ability to generate earnings will be the source of its interest payments, as well as the source for its principal repayments.
Earnings coverage ratios measure the relationship between the fixed interest charges the company is obligated to pay and the earnings available to meet those charges.
Earning power refers to earnings coverage. Earnings coverage is important because it is the source of interest payments and principal repayments. Long-term earnings are necessary because they create liquidity, solvency, and borrowing capacity for a company.
Following are three earnings coverage ratios that measure the ability of the company to make interest payments :
- Interest Coverage (Times Interest Earned) Ratio
- Fixed Charge Coverage (Earnings to Fixed Charges) Ratio
- Cash Flow to Fixed Charges Ratio