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The Cash Coverage Ratio formula determines if a business has enough funds to pay interest and operating costs. The ratio takes EBIT, non-cash expenses, and interest expense to show how much money a company has compared to its debt. A ratio greater than 1 is best, while less than 1 indicates bankruptcy.
The Cash Coverage Ratio formula is a way for accountants and business owners to determine if a business has adequate funds to pay interest and day-to-day operating costs. It will also help determine whether the company can make a profit or must spend all of its money to pay off debt. The ratio itself is easy to calculate and takes just a few steps. Answers greater than 1 are best, and answers less than 1 generally show that the business will go bankrupt soon.
The cash coverage ratio is a formula that takes three numbers: earnings before interest and taxes (EBIT), non-cash expenses like depreciation, and interest expense. Interest expense should only include money paid out, not discounts or premiums. Most bookkeepers, accountants, and accounting software can calculate these numbers if they are not known in advance. The number derived from the formula shows how much money a company has compared to its debt.
The formula starts by taking EBIT and adding it to non-cash expenses. If EBIT is $300 US Dollars (USD) and non-cash expense is $100 USD, the total is $400 USD. This number is divided by the interest expense. If the interest expense is $200 USD, for example, then the calculation is 400/200. This leaves 2, making a 2:1 ratio.
The remaining number represents the amount of money the company has to pay its expenses. In the example above, the company has $2 for every $1 of debt. The company will be able to pay off its debt and there will be a profit after all expenses.
If the number is less than 1, this leaves the company in a bad light. This means that the company cannot pay all of its debts. A number less than 1 is seen as an indicator that the business is going out of business, usually within a few years. The higher the number, the better the company does.
The cash coverage ratio is used as a proxy to show whether a given business can meet its financial obligations. It uses the actual costs and expenses of the business, so it is considered accurate in terms of showing the success of a business. If a business uses expense estimates, the cash coverage ratio may still be accurate, but only if the estimates are correct.
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