How Companies Use the Loan Loss Coverage Ratio
Companies measure their rainy day fund by using the loan loss coverage ratio. Your rainy day fund is the money you set aside in case you lose your job and stop making money. A company's loan loss coverage ratio is calculated by:
To use this equation, follow these steps:
Find the pretax income near the bottom of the income statement, the provision for loan losses in the assets portion of the balance sheet, and the net charge-offs in the expenses portion of the income statement.
Add the pretax income and the provision for loan losses.
Divide the answer from Step 2 by the net charge-offs to get loan loss coverage ratio.
If a bank lends someone money and that person doesn’t pay it back, then the bank has lost that money. Likewise, if a company sells a customer a product and the customer never pays the bill, then the company loses that money, too.
How much money should a company keep on hand to cover these losses? If a company has too much money on hand to cover losses, it isn’t using its assets efficiently, but if it has too little on hand, it risks insolvency. Of course, decreasing the net charge-offs is the best option, but a company should always have potential losses covered, as well.