CHAPTER 8 Analysis and interpretation of financial statements 345The interest coverage ratio is inversely related to an entity’s financial risk. A ratio less than 1 suggests
that an entity’s net finance costs exceed its EBIT — a situation that is unsustainable in the long run. The
interest coverage ratio will exceed 1 so long as the EBIT is greater than net finance costs. As an arbitrary
guide, the interest coverage ratio should not be below three times.
Debt coverage ratio
Debt needs to be serviced from cash flow, so it is useful to relate the entity’s cash generating capacity
to its long-term debt. The debt coverage ratio links the cash flows from operating activities with long-
term debt, and is found by dividing non-current liabilities by cash from operating activities. It is also a
measure of an entity’s ability to survive in the longer term and remain solvent, as it indicates how long
it will take to repay the existing long-term debt commitments at the current operating level. The ratio is
calculated as:
Non-current liabilities
=x times
Net cash flows from operating activitiesAnalysis of capital structure: JB Hi-Fi Ltd
Figure 8.11 reports the capital structure ratios for JB Hi-Fi Ltd for 2015 and 2014. It shows that JB
Hi-Fi Ltd funded every $1 of assets with 62 cents of debt in 2015, compared to 66 cents of debt in
- Funding approximately 60 per cent of the assets with debt reflects a medium reliance on debt and
suggests that the entity’s exposure to financial risk is not high. During recent past years, JB Hi-Fi Ltd
has pursued a debt reduction strategy with declining long-term borrowings. As revealed by the statement
of cash flows, the company was a net borrower in 2014 (cash proceeds from borrowings are shown as
$54 062 000), whereas in 2015 JB Hi-Fi Ltd repaid more debt than it borrowed (cash repayments associ-
ated with borrowings are shown as $40 113 000).
The EBIT of JB Hi-Fi Ltd adequately covers its net finance costs, suggesting the company does not
have interest-bearing debt that is a financial strain. The interest coverage is a function of interest-bearing
liability levels, interest rates and profitability levels. The less reliance on borrowings, combined with
higher EBIT, has increased the interest coverage ratio from 21.65 times in 2014 to 34 times in 2015.
This means that JB Hi-Fi Ltd’s EBIT covers its net finance costs about 34 times over, representing more
than an adequate safety margin.
2015 2014Debt ratio$551 534
$895 013100 61.62%
××==
$565 208
$859 841100 65.73%
××==Interest coverage ratio$201 459
$5 92734 times
==$191 522
$8 84521.65times
==Debt coverage ratio$171 198
$179 8960.95times
==
$213 015
$41 3265.15times
==F I G U R E 8 .11 Analysis of capital structure ratios for JB Hi-Fi Ltd