Market Overview

Terms Of The Trade: What Coverage Ratios Tell Investors About A Company's Debt Load

Share:
Terms Of The Trade: What Coverage Ratios Tell Investors About A Company's Debt Load

Debt is a part of business. Corporations employ debt to build their businesses bigger and faster than they could if they had to rely solely on their earnings

With that said, debt can also be a crippling burden, as interest payments eat away at returns, debt covenants put pressure on its management to massage their numbers and large loads of existing debt hurt chances of additional borrowing in the case of an economic downturn.

For these reasons, the accounting and investing community, in its wisdom, created debt coverage ratios like Times-Interest-Earned and Cash Flow-To-Debt.

TIE

The Times-Interest-Earned (TIE) ratio describes a company’s ability to cover its interest expenses with its reported earnings. Using a figure known as EBIT (earnings before interest and taxes), it is calculated as Net Income + Interest Expense + Income Tax Expense/Interest Expense.

Related Link: Mead Johnson Sales Could Inflect Higher, JPMorgan Says

So if Company X has a net income or “bottom-line” number of $1,000,000 and interest expense and tax expense are both $500,000, its EBIT would be $2,000,000 and you’d calculate the TIE this way: 2,000,000/500,000 = 4.

The higher a company’s TIE is, the more capable it is of covering its interest payments, although it’s helpful to compare it to other companies in its sector for some perspective.

Cash Flow-To-Debt Ratio

Similar to the TIE, what differentiates the cash flow-to-debt ratio is its use of free cash flow, as opposed to earnings. Some investors feel this gives a better picture of a firm’s ability to pay interest, as earnings are not synonymous with cash.

Free cash flow is, more or less, a company’s earnings per share plus non-cash expenses like depreciation and amortization, share-based compensation added back. This number is then divided by the total interest-bearing debt.

So, if Company X has free cash flow of $200,000 and interest bearing debt of $1,000,000, its cash flow-to-debt ratio is 0.2.

This means for every $1 in debt, a company has $0.20 of free cash. As you can probably guess, a cash flow-to-debt ratio of 1 or more is preferred.

Do you have ideas for articles/interviews you'd like to see more of on Benzinga? Please email feedback@benzinga.com with your best article ideas. One person will be randomly selected to win a $20 Amazon gift card!

 

Related Articles (SPY + SPX)

View Comments and Join the Discussion!

Posted-In: Cash Flow-to-Debt Ratio CFTDR debt Earnings Before Interest and Taxes EBIT InterestEducation General Best of Benzinga