Cover

Definition

1. Securities Trading

In the context of securities trading, to “cover” means to buy back contracts or stocks that were previously sold short. Investors engage in short selling when they predict the price of a stock will decrease. By buying back the stock at a lower price, they aim to profit from the difference.

2. Corporate Finance

In corporate finance, “cover” refers to the ability of a company to meet its fixed financial obligations such as bond interest, lease payments, and other annual charges from its earnings. This demonstrates the company’s financial health and capacity to satisfy its debt repayments and lease commitments.

3. Net-Asset Value

The amount of net-asset value that underlies a bond or equity security is also referred to as cover. Adequate coverage is vital for maintaining a bond’s safety rating, indicating that the company has sufficient assets to meet its obligations.

Examples

Example 1: Securities Trading

An investor sells 100 shares of XYZ Company short at $50 per share, predicting the price will drop. When the price falls to $40, the investor decides to cover the short by buying back the shares, thereby profiting $10 per share minus transaction costs.

Example 2: Corporate Finance

A corporation with an annual debt obligation of $1 million has earnings before interest, taxes, depreciation, and amortization (EBITDA) of $5 million. This indicates a coverage ratio of 5, suggesting the corporation comfortably covers its debt obligations from its earnings.

Example 3: Net-Asset Value

A company’s bond has a safety rating highly influenced by its coverage, which includes assets worth $100 million backing $50 million in bonds issued. This high asset-to-liability ratio reflects good coverage and a strong ability to meet bondholders’ claims.

Frequently Asked Questions (FAQs)

What does it mean to “cover a short position”?

To cover a short position means buying back the same stock or commodity contracts that were previously sold short to close out the position, ideally at a profit if the price has dropped.

How do companies ensure they cover their fixed financial obligations?

Companies ensure coverage of their financial obligations by maintaining sufficient earnings and liquidity to meet interest payments on bonds, lease payments, and other fixed charges.

Why is cover important for a bond’s safety rating?

Cover indicates a company’s ability to meet its debt obligations. Higher coverage signifies that a company has ample net assets, thereby reducing default risk and increasing the bond’s safety rating.

What is a Debt Coverage Ratio?

The Debt Coverage Ratio (DCR) is a financial metric that compares a company’s EBITDA to its debt service requirements. A higher DCR indicates a company’s higher ability to service its debt.

Debt Coverage Ratio

The Debt Coverage Ratio (DCR) measures a company’s ability to service its debt using its earnings. It’s calculated as EBITDA / Total Debt Service.

Short Selling

Short selling involves selling borrowed stocks with the intention of buying them back at a lower price, thus profiting from the price difference.

EBITDA

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is a measure of a company’s overall financial performance, primarily used to assess a company’s operating profitability.

Leverage Ratio

A leverage ratio evaluates the amount of debt a company has relative to its equity or assets, reflecting the financial risk involved in the company’s capital structure.

Online References

Suggested Books for Further Studies

“Corporate Finance” by Stephen A. Ross, Randolph W. Westerfield, and Jeffrey F. Jaffe
“Investment Valuation: Tools and Techniques for Determining the Value of Any Asset” by Aswath Damodaran
“Short Selling: Strategies, Risks, and Rewards” by Frank J. Fabozzi and Harry Markopolos

Fundamentals of Cover: Finance Basics Quiz

### What does it mean to "cover a short position"? - [x] To buy back the stock previously sold short. - [ ] To sell additional stocks. - [ ] To hedge against price increases. - [ ] To avoid financial obligations. > **Explanation:** Covering a short position involves buying back the same stock sold short to close the position, typically after a decrease in the stock’s price. ### How can companies ensure they cover their fixed financial obligations? - [x] By maintaining sufficient earnings and liquidity. - [ ] By increasing their debt levels. - [ ] By issuing more stock. - [ ] By reducing operational expenditures only. > **Explanation:** Companies ensure coverage of their fixed financial obligations through adequate earnings and liquidity, allowing them to meet interest and lease payments. ### Why is coverage important for a bond’s safety rating? - [x] It indicates the company’s capacity to meet its obligations. - [ ] It reflects the company’s investment portfolio size. - [ ] It shows potential for stock price appreciation. - [ ] It limits the company’s revenue potential. > **Explanation:** Adequate coverage demonstrates that a company has sufficient net-asset value to meet its obligations, enhancing the bond's safety rating. ### What is the Debt Coverage Ratio (DCR)? - [ ] A measure of stock performance. - [ ] The proportion of equity to total assets. - [x] A metric comparing a company’s EBITDA to its debt service requirements. - [ ] An indicator of market risk. > **Explanation:** The DCR involves comparing a company's EBITDA with its total debt service requirements to assess its ability to repay debt. ### Which financial metric provides insight into a company's operating profitability? - [ ] Debt Coverage Ratio - [x] EBITDA - [ ] Leverage Ratio - [ ] Price-to-Earnings Ratio > **Explanation:** EBITDA is a measure of a company's overall financial performance, focusing on operating profitability by excluding interest, taxes, depreciation, and amortization. ### In what scenario would an investor cover their short position? - [ ] After a stock price surge. - [x] When the stock price falls. - [ ] When the company declares dividends. - [ ] When the stock reaches a two-year high. > **Explanation:** An investor would cover their short position when the stock price falls, allowing them to buy back the stock at a lower price than initially sold. ### What does a high Debt Coverage Ratio signify? - [x] A strong ability to service debt. - [ ] Excessive debt levels. - [ ] An over-leveraged company. - [ ] Limited operational efficiency. > **Explanation:** A high Debt Coverage Ratio indicates a strong ability of the company to service its debt obligations, suggesting financial stability. ### In corporate finance, what does "cover" refer to? - [ ] Buying insurance policies. - [x] Meeting fixed annual charges out of earnings. - [ ] Short selling securities. - [ ] Hedging against currency fluctuations. > **Explanation:** In corporate finance, "cover" refers to the company’s capacity to meet its fixed annual financial obligations from its earnings. ### How is the adequacy of coverage linked to a bond’s safety rating? - [ ] Through the company’s stock market performance. - [x] By assessing the net-asset value supporting the bond. - [ ] Based on the company's growth rate. - [ ] Via the company's dividend yield. > **Explanation:** The adequacy of coverage involves evaluating the net-asset value that supports the bond, ensuring the company can meet financial obligations, thereby impacting the bond's safety rating. ### What impact does a high Asset-to-Liability ratio have on coverage? - [ ] Decreases coverage. - [ ] No impact. - [ ] Makes the bond riskier. - [x] Enhances the coverage. > **Explanation:** A high Asset-to-Liability ratio enhances coverage, indicating that the company has enough assets to comfortably meet its debt obligations.

Thank you for exploring the concept of “cover” in various financial contexts and taking our quiz to deepen your understanding!