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Coverage Ratios

The second category of leverage ratios are coverage ratios. These ratios are
computed from information available in the profit and loss account. For a notional firm, in the ordinary course of business, the claims of creditors are not met out of the sale proceeds of the permanent assets of the firm. The obligations of a firm are normally met out of the earnings or operating profits. These claims consist of (i) interest on loans, (ii) preference dividend. and (iii) amortization of principal or repayment of the installment of loans or redemption of preference capital on maturity, The soundness of a firm, from the view-point of long-term creditors, lies in its ability to service their claims. This ability is indicated by the coverage ratios. The coverage ratios measure the relationship between what is normally available from operations of the firms and the claims of the outsiders. The important coverage ratios are: (i) interest coverage, (ii) dividend coverage, (iii) total coverage, (iv) total cash flow coverage, and (v) debt service coverage ratio.

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