COVERAGE RATIOS - Accounts and Finance for Managers

These ratios are computed to know the solvency of the firm in making the periodical payment of interest and preference dividends. The interest and preference dividends are to be paid irrespective of the earnings available in the hands of the firm. In other words, these are known as fixed commitment charge of the firm.

Interest Coverage Ratio

The firms are expected to make the payment of interest on the amount of borrowings without fail This ratio facilitates the prospective lender to study the strength of the enterprise in making the payment of interest regularly out of the total income. To study the capacity in making the payment of interest is known as interest coverage ratio or debt service coverage ratio.

The ability or capacity is analysed only on the basis of Earnings before interest and taxes (EBIT) available in the hands of the firms.

Greater the ratio means that better the capacity of the firm in making the payment of interest as well as greater the safety and vice versa

Interest coverage ratio=Earning before interest and taxes Interest


Lesser the times the ratio means that meager the cushion of the firm which may lead to affect the solvency position of the firm in making payment of interest regularly.

Dividend Coverage Ratio

It illustrates the firms’ ability in making the payment of preference dividend out of the earnings available in the hands of the firm after the payment of taxation. If the size of the Profits after taxation is greater means that greater the cushion for the payment of preference dividend and vice versa.

The preference dividends are to be paid without fail irrespective of the profits available in the hands of the firm after the taxation.

Dividend coverage ratio=Earnings after taxatation/Preference Dividend


Standard norm of the ratio

Higher the ratio means that the firm has greater cushion in meeting the needs of preference dividend payment against Earnings after taxation(EAT) and vice versa

Profitability Ratios

The ratios are measuring the profitability of the firms in various angles viz

  • On sales
  • On investments
  • On capital employed and so on

While discussing the measure of profitability of the firm, the profits are normally classified into various categories

  • Gross Profit
  • Net Profit
  • Earnings before interest and taxes
  • Earnings after taxation and so on

All profitability ratios are normally expressed only in terms of (%). The return is normally also in percentage.

GP Ratio: The ratio elucidates the relationship in between the Gross profit and sales volume.

It facilitates to study the profit earning capacity of the firm out of the manufacturing or Trading operations.

Gross Profit Ratio=Gross Profit ×100Sales


Standard Norm of the ratio:

Higher the ratio is better the position of the firm which means that the firm earns greater profits out of the sales and vice versa.

NP Ratio: The ratio expresses the relationship in between the Net profit and sales volume. It facilitates to portray the overall operating efficiency of the firm. The net profit ratio is an indicator of over all earning capacity of the firm in terms of return out of sales volume.

Net Profit Ratio=Net Profit ×100Sales

Standard Norm of the Ratio:

Higher the ratio is better the operating efficiency of the firm which means that the firms earns greater volume of both operating as well as non operating profit out of sales and Vice versa.

Operating profit ratio: The operating ratio is establishing the relationship in between the cost of goods sold and operating expenses with the total sales volume.

Operating ratio=Cost of goods sold +Operating expenses×100/Net Sales

Standard norm of the ratio

Lower the ratio is better as well as favourable position for the firm, which highlights % of absorption cost of goods sold and operating expenses out of sales and vice versa. The lower ratio leads to have the higher margin of operating profit.

Return on Assets: This ratio portrays the relationship in between the earnings and total assets employed in the business enterprise. It highlights the effective utilization of the assets of the firm through the determination of return on total assets employed.

Return on Assets=Net Profit After Taxes×100/Average Total Assets

Standard norm of the ration

Higher the ratio illustrates that the firm has greater effectiveness in the utilization of assets, means greater profits reaped by the total assets and vice versa.


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