Why coverage ratio matters to a first-time founder
A coverage ratio indicates how much capacity a business has to meet a specified obligation. Lenders use these ratios to assess risk and set covenants. Founders use them to see whether a small fall in earnings could threaten payments. The ratio must always name its numerator, denominator, and period.
Examples of coverage ratio
A company has £150,000 of earnings before interest and tax and £60,000 of annual interest. Its interest coverage ratio is £150,000 divided by £60,000, or 2.5 times. That means the chosen earnings measure covers interest 2.5 times. A debt-service ratio including principal repayments would produce a different result.
Common misunderstanding
There is no single universal coverage ratio. Interest coverage, debt-service coverage, and asset coverage answer different questions and use different inputs. A ratio above 1 does not automatically mean comfortable capacity. Volatile earnings, near-term cash timing, and the exact loan definition can make the same headline number misleading.
When to use it
Use the ratio specified in a loan agreement exactly as defined, especially for covenant testing. For internal planning, choose the obligation that could constrain cash and run downside cases. Compare periods only when calculations are consistent. Seek advice where accounting adjustments or legal consequences of a breach are unclear.