Cash coverage ratios are the coverage measures that divide a cash figure, or an earnings figure with the non-cash charges added back, by an obligation falling due in the same period, and the quotient says how many times over that cash covers that obligation. The word cash is what marks the family off from the rest of the coverage measures, which build their numerators out of accrual earnings and stop there. No accounting standard fixes who belongs to the family or how any member is worded, so the agreement or program rule that imposes one of these ratios writes its own definition and that wording governs, the same pattern the wider family of debt ratios runs on.
Why a Coverage Test Reaches for Cash at All
An obligation is settled in cash. Earnings are not cash, because the income statement charges amounts that moved no money in the period and books revenue that has not been collected. A coverage test built on earnings alone therefore answers a question standing next to the one a lender asked, and the gap between the two is exactly the size of the non-cash items sitting in the earnings figure.
The correction is mechanical. Start from an earnings figure, then add back the amounts that never left the bank.
The Two Reasons Something Gets Added Back
A worked federal-extension version of the test makes the reasoning explicit, and the two reasons are not the same reason.
Writing on loan renewals for farm businesses, the University of Illinois sets out the calculation of capital debt repayment capacity, the numerator of its coverage ratio. The starting point is the projected net farm income from the business, then adjustments are made by adding in non-farm income, term debt interest and depreciation, where term debt interest is added back because it is part of the annual debt service requirements and depreciation is added back because it is a non-cash expense, while family living draws and income tax expense are subtracted out (farmdoc daily, University of Illinois, 2017).
Read those two add-backs apart, because they generalize differently.
- Depreciation comes back because it is not cash. Every non-cash charge in the earnings figure belongs to this reason, which is why the amortization of an intangible comes back on the same logic.
- Interest comes back because it is already counted downstairs. Anything that appears in the denominator has to be stripped out of the numerator, or the test charges the business for the same dollar twice.
The second reason is the one that gets missed, and missing it understates coverage rather than overstating it.
A Worked Example
Say a firm projects its coming year and its bank wants the coverage read on cash rather than on profit.
Net income projected for the year $310,000
add depreciation, a non-cash charge $ 74,000
add interest on term debt, counted below $ 52,000
less owner draws $120,000
less income tax expense $ 68,000
cash available for term debt = $248,000
Scheduled term debt principal for the year $154,000
Scheduled term debt interest for the year $ 52,000
annual debt service = $206,000
Coverage ratio $248,000 / $206,000 = 1.20
Repayment margin $248,000 - $206,000 = $42,000Both figures come out of the same two inputs. The ratio states the cushion as a multiple and the margin states it in dollars, and a business with a thin margin on large numbers can carry the same ratio as one with a comfortable margin on small numbers.
How the Answer Is Read
One is the break-even reading, since coverage of exactly one means the cash arrives and leaves with nothing behind it. The Illinois guidance puts the working threshold slightly above that: the coverage ratio needs to be at least 1.0, but a higher ratio is preferred to allow for any unexpected shortfalls in the projected cash flow, which can come about through lower prices, lower yields or higher costs than the original projections used (farmdoc daily, University of Illinois, 2017).
That is the whole argument for headroom. The numerator is a projection, so the cushion is not a preference about risk appetite, it is the allowance for the projection being wrong.
Not Every Coverage Ratio Is a Cash One
The family name reaches wider than cash, and its one member written into federal statute does not involve cash or earnings at all. Under the law governing the capital structure of investment companies, it is unlawful for a registered closed-end company to issue or sell any class of senior security unless, where that class represents an indebtedness, immediately after the issuance or sale it will have an asset coverage of at least 300 per centum, and where the class is a stock, an asset coverage of at least 200 per centum (15 U.S. Code section 80a-18(a)).
Note when that test bites. The statute applies it immediately after the issuance or sale, so it is a condition on a transaction at a moment rather than a reading of how a period went, which is the opposite of every cash member of the family.
What Cash Coverage Is Confused With
The neighboring tests differ by what sits in the denominator and what the numerator is allowed to contain, and each has its own reading.
- Times interest earned stops at interest and builds its numerator from accrual earnings before interest and taxes, so it is the accrual sibling of a cash interest coverage test, set out in times interest earned ratio.
- Debt service coverage widens the denominator to the scheduled principal falling due alongside the interest, the shape in debt service coverage ratio.
- Fixed charge coverage widens the denominator further still, and what a document counts as a fixed charge is settled in fixed charge coverage ratio.
- The cash ratio is not a coverage test at all. It divides cash and equivalents by total current liabilities at one date, which is a stock reading rather than a period one, and it belongs with the liquidity ratios.
Common Questions
Cash available for the obligation divided by the obligation falling due in the same period. Which earnings figure starts the numerator, which charges come back, and whether the denominator stops at interest or reaches principal are all set by the document imposing the test rather than by any standard.
Higher means more cushion against a projection that misses, so more is better as a reading of safety. It is not free, because the cash sitting above the obligation is cash not deployed elsewhere, and a ratio that climbs while revenue is flat usually says the business is holding back rather than performing.
Because it appears in the denominator. Leaving it in both places charges the same dollar twice and understates the coverage the business actually has.
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