Skip to main content
diversification.com
← Back to I Definitions

Incremental coverage ratio

LINK_POOL:

What Is Incremental Coverage Ratio?

The Incremental Coverage Ratio is a specific financial ratio used within the realm of financial analysis to assess a company's ability to cover additional interest expense associated with new [debt](https://diversification.com/term/debt]. This metric helps evaluate the impact of new borrowing on a company's debt-servicing capacity, offering a forward-looking perspective on its financial health and solvency. The Incremental Coverage Ratio is particularly relevant when a company considers taking on more leverage.

History and Origin

The concept of coverage ratios, including the Incremental Coverage Ratio, evolved alongside the increasing complexity of corporate finance and the need for robust methods to assess a company's ability to meet its financial obligations. As businesses grew and began to rely more heavily on external financing, creditors and investors required more sophisticated tools to evaluate credit risk. The Securities and Exchange Commission (SEC) has long emphasized the importance of transparent financial disclosures, including a company's ability to meet its debt obligations. Guidance from the SEC on Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) highlights the need for companies to discuss their liquidity and capital resources, including material cash requirements from known contractual obligations10, 11, 12. This regulatory emphasis underscores the analytical importance of metrics like the Incremental Coverage Ratio in providing a comprehensive view of a company's financial condition.

Key Takeaways

  • The Incremental Coverage Ratio assesses a company's capacity to handle additional debt by measuring its ability to cover new interest expenses.
  • It is a forward-looking metric crucial for evaluating the impact of new borrowing on a company's financial stability.
  • A higher Incremental Coverage Ratio generally indicates a stronger ability to take on more debt.
  • This ratio is a vital tool for lenders and investors when making decisions about extending credit or investing in a company.
  • The ratio helps companies understand the implications of increasing their leverage on their overall capital structure.

Formula and Calculation

The formula for the Incremental Coverage Ratio is as follows:

Incremental Coverage Ratio=Projected Earnings Before Interest and Taxes (EBIT)Current Interest Expense + New Interest Expense\text{Incremental Coverage Ratio} = \frac{\text{Projected Earnings Before Interest and Taxes (EBIT)}}{\text{Current Interest Expense + New Interest Expense}}

Where:

  • Projected Earnings Before Interest and Taxes (EBIT): The company's anticipated earnings before accounting for interest and taxes, incorporating the expected impact of the new debt-funded project or operation.
  • Current Interest Expense: The existing interest obligations on the company's outstanding debt.
  • New Interest Expense: The additional interest payments that will arise from the proposed new debt.

Interpreting the Incremental Coverage Ratio

Interpreting the Incremental Coverage Ratio involves comparing the calculated ratio to benchmarks, industry averages, and the company's internal targets. A ratio significantly greater than 1 suggests that the company's projected earnings can comfortably cover both its existing and proposed new interest expenses. This indicates a healthy capacity to take on additional debt.

Conversely, an Incremental Coverage Ratio close to or below 1 signals potential challenges. A ratio of 1 means that the projected EBIT would only just cover the total interest expense, leaving no buffer for unforeseen circumstances or declines in earnings. A ratio below 1 indicates that the company's projected earnings would not even be sufficient to meet its total interest obligations, making the additional debt highly risky and potentially leading to financial distress or even bankruptcy. Lenders typically look for a comfortable margin to ensure the borrower's ability to repay, and a low Incremental Coverage Ratio would likely deter new financing.

Hypothetical Example

Suppose XYZ Corp. is considering taking out a new loan to expand its operations.

  • Current EBIT: $5,000,000
  • Current Interest Expense: $500,000
  • New Loan Amount: $10,000,000
  • Interest Rate on New Loan: 6%
  • Projected increase in EBIT from expansion: $1,500,000

First, calculate the New Interest Expense:
New Interest Expense = $10,000,000 * 0.06 = $600,000

Next, calculate the Projected EBIT:
Projected EBIT = Current EBIT + Projected increase in EBIT = $5,000,000 + $1,500,000 = $6,500,000

Now, apply the Incremental Coverage Ratio formula:

Incremental Coverage Ratio=$6,500,000$500,000+$600,000=$6,500,000$1,100,000≈5.91\text{Incremental Coverage Ratio} = \frac{\$6,500,000}{\$500,000 + \$600,000} = \frac{\$6,500,000}{\$1,100,000} \approx 5.91

In this example, XYZ Corp.'s Incremental Coverage Ratio is approximately 5.91. This indicates that their projected earnings are nearly six times the total interest expense (current plus new). This is a strong ratio, suggesting that XYZ Corp. has a robust capacity to take on the new loan and manage its increased cash flow obligations.

Practical Applications

The Incremental Coverage Ratio is a critical tool for various stakeholders in the financial world. For corporate finance managers, it helps in strategic planning related to capital structure and evaluating the viability of new investment projects that require additional financing. It provides insight into how much additional debt a company can safely take on without jeopardizing its financial stability.

Lenders and banks heavily rely on this ratio when assessing loan applications. A favorable Incremental Coverage Ratio provides assurance that the borrower will be able to service the additional debt, reducing the lender's exposure to credit risk. Similarly, investors who are considering purchasing corporate bonds or other debt instruments issued by a company will analyze this ratio to gauge the safety of their investment. The Federal Reserve's Financial Stability Report, for instance, frequently assesses trends in business and household leverage as potential vulnerabilities to the financial system, highlighting the broader economic importance of debt coverage7, 8, 9. Global debt, including corporate debt, has been a persistent concern for international bodies like the International Monetary Fund and the OECD, with reports noting high levels of outstanding debt and rising interest costs4, 5, 6.

Furthermore, companies with existing debt covenants might use this ratio to ensure that new borrowing does not violate any conditions set by previous lenders.

Limitations and Criticisms

While the Incremental Coverage Ratio offers valuable insights, it does have limitations. It relies on "projected" EBIT, which are inherently estimates and subject to uncertainty. Actual future earnings may differ significantly from projections due to economic downturns, unexpected operational issues, or changes in market conditions. This dependence on forecasts can make the ratio less reliable during periods of high economic volatility or for companies in rapidly changing industries.

Another criticism is that the ratio primarily focuses on earnings and does not directly account for cash flow availability for debt service. A company might have strong EBIT but poor cash flow due to non-cash expenses or significant working capital needs. Therefore, it's crucial to use the Incremental Coverage Ratio in conjunction with other metrics, such as cash flow coverage ratios, to get a more complete picture of a company's liquidity and debt-servicing capacity. Additionally, this ratio, like other single financial metrics, does not capture the full complexity of a company's financial health or the macroeconomic environment. For example, a 2019 Federal Reserve Bank of St. Louis economic letter discussed the rise of corporate debt since the Great Recession and concerns about its potential threats to financial stability3. Similarly, a Federal Reserve Board paper emphasizes that accounting for corporate debt maturity is crucial for understanding business cycle dynamics1, 2.

Incremental Coverage Ratio vs. Fixed-Charge Coverage Ratio

The Incremental Coverage Ratio and the Fixed-Charge Coverage Ratio both assess a company's ability to meet its financial obligations, but they serve different purposes and focus on different aspects of debt coverage.

The Fixed-Charge Coverage Ratio measures a company's ability to cover all its fixed charges, including both interest expenses and other fixed obligations like lease payments, sinking fund payments, and preferred dividends, from its earnings before interest, taxes, and fixed charges. It provides a comprehensive view of a company's existing ability to meet all its recurring fixed financial commitments.

In contrast, the Incremental Coverage Ratio specifically evaluates the impact of new debt on a company's ability to service its debt. It considers the projected increase in interest expense from new borrowing and assesses whether the projected increase in earnings can adequately cover these additional costs, along with existing interest. While the Fixed-Charge Coverage Ratio provides a snapshot of current debt-servicing capacity, the Incremental Coverage Ratio is a forward-looking tool used for decision-making related to new financing and expansion.

FAQs

What is a good Incremental Coverage Ratio?

A good Incremental Coverage Ratio is typically significantly greater than 1. A ratio of 2 or higher is often considered healthy, indicating that projected earnings are at least double the total interest expense (current and new). This provides a comfortable buffer for the company. However, what constitutes a "good" ratio can vary by industry, company size, and prevailing economic conditions.

Why is the Incremental Coverage Ratio important for lenders?

The Incremental Coverage Ratio is crucial for lenders because it helps them assess the risk of a new loan. By calculating this ratio, lenders can determine if a company's projected earnings will be sufficient to cover the additional interest payments from the new debt, thereby reducing the likelihood of default.

Can the Incremental Coverage Ratio be negative?

Yes, the Incremental Coverage Ratio can be negative if the projected Earnings Before Interest and Taxes (EBIT) are negative, meaning the company is expected to incur an operating loss even before accounting for interest and taxes. A negative ratio would indicate a very high risk and strongly suggest that taking on new debt is ill-advised.

How does new debt impact the Incremental Coverage Ratio?

New debt increases the denominator of the Incremental Coverage Ratio by adding to the total interest expense. If the projected increase in earnings (numerator) due to the new debt-funded initiative is not proportionally higher than the increase in interest expense, the ratio will decline. This highlights the importance of ensuring that new debt generates sufficient additional earnings to maintain or improve the company's debt coverage.

What financial statements are needed to calculate the Incremental Coverage Ratio?

To calculate the Incremental Coverage Ratio, you primarily need information from a company's financial statements, specifically the income statement for current EBIT and interest expense, and projections for future EBIT and new interest expense associated with the planned debt.