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Analyzing a Company's Coverage Capability

Corporate coverage is essentially a company’s ability to meet the obligations of its preferred stock and bonds. This will greatly influence the company’s ability to obtain credit in the future. So when the coverage ratio is more attractive, loan terms are going to be more attractive, bond ratings will be higher, and bond rates will tend to be lower. An important coverage measurement is bond interest coverage which is the ratio of earnings before interest and taxes (EBIT) to the annual interest owed on bonds. This ratio will depict the company’s ability to fulfill its outstanding bond payments. To analyze this further, a ratio of 1:1 will show that the company had just enough earnings to cover its bond obligations. This could be viewed negatively in that if the company’s earnings were to fall, the company may find itself in default.

Bond Interest Coverage = EBIT / Bond Interest Expense

The preferred dividend ratio will measure a company’s ability to fulfill fixed dividend payments to preferred stock holders. This ratio is computed from net income, not EBIT, because preferred dividend payments are made after taxes are paid; bond payments are made before taxes are paid. Preferred dividends are fixed because this type of security pays a fixed dividend based on a percentage of the security’s par value. Preferred stock holders give up their voting rights in an exchange for this fixed dividend payment which are fulfilled before dividends paid to holders of common stock.

Preferred Dividend Coverage = Net Income / Preferred Dividends

One last important coverage ratio is net tangible asset value per bond which will provide an inside view at the likelihood that, in the event of a bankruptcy, bond holders will be able to recover their principal investment. In the event of a bankruptcy or failure, companies are forced to sell assets, fulfill its current liabilities, and pay bond holders. This ratio describes the amount of tangible assets to each bond, or the amount of tangible assets backing each bond.

Net Tangible Asset Value per Bond = (Tangible Assets – Current Liabilities) / Number of Outstanding Bonds

An example may help to explain these concepts:

All of the figures used to compute the above ratios can be found on XYZ’s income statement (XYZ is our test company for this example). With the figures that are found on the income statement we can compute XYZ’s Bond Interest Coverage.

Earnings Before Interest & Taxes / Bond Interest Expense = Bond Interest Coverage

$211,000(EBIT) / $13,000 (Bond Interest Expense) = 16.23

From this ratio we can conclude that XYZ has $16.23 for every dollar owed to bond holders as interest payments. It is safe to assume that this company may not be near default on its bond payments. Now we can figure out if the company has enough to fulfill its preferred stock payments. From the income statement we can find that XYZ’s preferred stock dividends total $4,960 ($62,000 par value x 0.08 interest = $4,960). You will also need net income, which can also be found in the income statement.

$246,504 (Net Income) / $4,960 (Preferred Dividends) = 49.69

This tells us that XYZ has $49.69 for every dollar owed to preferred stock holders in the form of dividends, and there is almost no chance of default on these obligations. But to gain a more clear view of all obligations, the Net Tangible Asset Value per Bond will need to be computed. First you must find the amount of tangible assets. Again from the income statement:

Tangible Assets=
$942,000 (Total Assets) – $46,000 (Intangible Assets) = $896,000

XYZ has issued 260 bonds at face a value of $1,000. Net Tangible Assets Value per Bond can be found:

Net Tangible Asset Value per Bond =
$896,000 (Tangible Assets) - $362,000 (Current Liabilities) / 260 bonds = 2053.85

From this we found that XYZ has $2,053.85 backing each $1,000 par value bond that was issued. Bond holders in this case are fairly pleased because XYZ has a high credit rating due to its ability to meet its bond obligations.

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