(^324) Financial Management
Interest Coverage Ratio The interest coverage ratio (also referred to as the times
interest earned ratio) is simply defined as:
, /0
) / 210/ / -
To illustrate, suppose the most recent earnings before interest and taxes (EBIT) for
Vitrex Company were Rs. 120 million and the interest burden on all debt obligations
were Rs. 20 million. The interest coverage ratio, therefore, would be 120/20 = 6. What
does it imply? It means that even if EBIT drops by 83'h per cent, the earnings of Vitrex
Company cover its interest payment.
Though somewhat commonly used, the interest coverage ratio has several deficiencies:
(i) It concerns itself only with the interest burden, ignoring the principal repayment
obligation. (ii) It is based on a measure of earnings, not a measure of cash flow. (iii) It
is difficult to establish a norm for this ratio. How can we say that an interest coverage
ratio of 2, 3, 4, or any other is adequate?
Cash Flow Coverage Ratio This may be defined as:
-/
, /0 $0 / 3 .3
) , /4 0 65/ 0 4 5 45 /2
++ + -To illustrate, consider a firm:
Dcpreciation Rs. 20 lakhs
EBIT Rs. 120 lakhs
Interest on debt Rs. 20 lakhs
Tax rate 50%
Loan repayment instalment Rs. 20 lakhs
The cash flow coverage ratio for this firm is:
(^) =
+It may be noted that in calculating the cash flow coverage ratio the loan repayment
amount in the denominator is adjusted upward for this tax factor because the loan
repayment amount, unlike the interest, is not a tax-deductible payment.
The cash flow coverage ratio is a distinct improvement over the interest coverage ratio
in measuring the debt capacity; it covers the debt' service burden fully and it focuses on