The cash coverage ratio is an important metric that helps to measure the soundness of a company’s financial position. In other words, the Cash Coverage Ratio helps to understand whether the entity can meet all its interest expenses.
What’s the Cash Coverage ratio(CCR)?
The cash Coverage ratio is the ratio of total cash available over the interest expense.
Let’s understand this topic better with an example.
Assume two companies – Large tree and Small tree with Cash Coverage ratios of 10x and 20x.
Small tree Company’s available cash is so high that it can meet 20 times of interest expense. In other words, the availability of cash is such that it can repay 20 months of interest expense altogether in a month.
The large tree coverage ratio is also positive. It’s a 10 multiple of the interest expense.
Given a choice, Investors choose to opt for a Small tree company.
How do you Calculate the Cash Coverage Ratio?
Firstly, we will need to get a clear understanding of the numerator and denominator in the Cash Coverage ratio.
Total Cash Available is the amount of profit available without considering the non-cash expense such as depreciation and amortization.
Let’s put it another way. Earnings before interest and tax along with the non-cash expenses equal the Cash available. Therefore, we can get all the data from the Statement of Profit and Loss itself.
The calculations here are simple. The lender will provide this information to the business in the debt agreements or through periodical emails or messaging apps. But we need to ensure that interest on all debt is considered.
Business does not have to have just one debt. There is a good chance of having multiple obligations. So, considering all interest expenses is key here.
Also Read: PV Ratio
Why’s CCR Important?
Business runs on either Equity or Debt financing.
Debt Finances come up with Covenants like maintaining ratios, submitting periodical statements, audit reports, etc. The list varies based on the type and purpose of debt.
The cash Coverage ratio is one of the prescribed ratios.
Financial Institutions look for a higher coverage ratio. That’s because it talks about liquid assets to meet their financial obligations. A low ratio could indicate that the company may not have enough funds to pay off its debt in the short term.
Equity investors also check for these. The coverage ratio can also be used to compare companies in the same industry, as it provides insight into their respective financial situations.
To get an accurate picture of a company’s financial health, it’s important to look at other metrics such as the debt-to-equity ratio and other liquidity ratios, in addition to this CCR.
The cash coverage ratio can assist a company in forecasting future cash requirements by assisting it in identifying its liquidity requirements and assessing its capacity to cover its costs in the case of a crisis. Banks, Lenders, insurance firms, and other financial institutions can all benefit from knowing their cash coverage ratios. It aids them in the administration of cash.