The term “cover” in the financial context can refer to different actions, depending on the situation. It generally involves meeting or fulfilling an obligation. Below are the three distinct definitions of “cover” as they relate to finance:
Cover in Short Selling
Covering is the action taken by an investor to buy back contracts or securities that were previously sold short. In short selling, an investor borrows and sells securities with the hope of buying them back at a lower price.
- Example: An investor sells short 100 shares of XYZ stock at $50 each. By the end of the trading day, XYZ’s price drops to $45. The investor buys back the 100 shares, covering the short position and earning a profit of $5 per share.
Cover in Corporate Finance
In corporate finance, cover refers to the ability of a company to meet its fixed annual charges, such as bond interest payments, lease agreements, and other obligations out of its earnings.
- Example: A company has annual bond interest payments of $2 million. Its earnings before interest and taxes (EBIT) are $10 million. The cover for these fixed annual charges is calculated as EBIT divided by the annual bond interest payments, which equals 5. This indicates the company earns five times what is needed to cover its bond interest payments.
Cover in Terms of Net-Asset Value
This definition pertains to the amount of net-asset value (NAV) underlying a bond or equity security. Coverage is crucial for evaluating the safety of a bond’s rating.
- Example: A bond with a high NAV coverage is considered safer because it indicates that the issuing entity has substantial assets backing it.
Applicability and Importance
Short Selling and Risk Management
- Importance: Helps manage risk and lock in profits or mitigate losses.
- Considerations: Timely covering is critical in volatile markets to avoid unlimited losses.
Corporate Finance
- Importance: Measures the company’s financial health and stability.
- Considerations: Investors and analysts closely watch a company’s ability to meet its obligations to assess creditworthiness and investment potential.
Net-Asset Value and Bond Ratings
- Importance: Influences the safety rating of bonds which impacts investment decisions.
- Considerations: High coverage typically implies lower risk.
Related Terms
- Debt Coverage Ratio: The Debt Coverage Ratio (DCR) is a financial metric that compares a company’s operating income to its debt obligations.
- Formula:
$$ \text{DCR} = \frac{\text{Net Operating Income}}{\text{Total Debt Service}} $$
- Short Selling: The practice of selling assets or securities not currently owned by the seller, typically borrowed, with the aim to purchase back at a lower price.
FAQs
Q: Why is covering important in short selling?
Q: What is a good debt coverage ratio?
Q: How does NAV coverage affect bond safety?
Summary
“Cover” is a multifaceted term in finance, encompassing actions from rebuying short-sold contracts to ensuring corporate financial obligations are met, and assessing the safety of bonds. Understanding and applying the concept appropriately aids in risk management, financial stability assessment, and investment decisions.
For further reading, see the related entry on [Debt Coverage Ratio].
