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.
Related Terms
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
- Investopedia - Short Covering
- Corporate Finance Institute - Debt Service Coverage Ratio
- Investing Answers - Coverage Ratio
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
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