Doing example 3 in FRA and it asks what would happen to the ratio if it was capitalized compared to if it wasn’t. Without capitalization it’s simple, and you plug in the numbers from the Income statement.
I dont understand why when Interest is capitalized the Dep X is added to EBIT. Interest CR = EBIT + Dep X / Int X.
With interest now being capitalized, we should have a higher dep X because the interest has been capitalized to Assets and the dep X increases due to this. If the Dep X increases then shouldn’t it be:
Interest Coverage Ration = EBIT - Dep X / Int X?
The higher dep x now will make the EBIT from the IS shown from prior to capitalization smaller.
I did the blue box without reading the section. It states to get a true picture of companys interest coverage ratio, the entire amount of the interest expenditure both the capitalized and and expensed portion should be included.
That’s why my answer was off. Here we’re looking for true picture but not real numbers.
Since you need to make adjustment where you include capitalized interest in interest expense, you also need to add back the portion of deprecation that pertains to the capitalized interest, that had been initially subtracted to get to the EBIT.
So essentially we to get a true picture of INTEREST COVERAGE RATIO, if we have a company that has capitalized components — we need to make an assumption the company is expensing everything to get a true picture of the ICRatio.
I’m having a similar issue trying to wrap my mind around this concept of capitalizing interest.
Like @cipherap15 - I also thought that with the capitalization of interest, it is not added to Interest Expense, but rather depreciated and incorporated by deducting into EBIT.
Under that logic, the Interest Coverage ratio should appear smaller…right?
But in this bluebox example 3, the Depreciation and capitalized interest are both being added to the numerator and denominator, respectively. Why is it doing this? Is it because we are trying to reverse the effect of capitalization of interest? (btw, I’ve been stuck on this for over an hour…it’s driving me crazy)
Please could someone explain this? Is my logic correct regarding when interest is capitalized, the depreciation expense is deducted from EBIT and Interest Expense is kept lower (since interest is now part of the asset, therefore should be depreciated in the Income statement overtime)?
Also, for this blue box example, (reading 16, Example 3), the “Solution to 1” states:
“For 2006, the interest coverage ratio of 11.68 that includes capitalised interest is substantially lower than the ratio without capitalised interest”
Does this statement imply that the 11.68 is WITH or WITHOUT the interest being capitalised?
I thought that the 11.68 in 2006 in this scenario is NOT capitalizing interest, therefore it is being restated as before capitalization of interest (adding back the interest expense and adding back the depreciation from EBIT).
So, Interest Coverage ratio is EBIT / Interest Expense.
When we decide to capitalize interest when dealing with long lived assets, we are still theoretically making interest payments, but they are not showing up as interest expense, so they’re initially not included within our calculation.
For analytical purposes, to get a better idea of how much Interest Coverage we truly do have, we must add our capitalized interest portion to Interest Expense to give us a true understanding of our interest payments.
Also, since we subsequently increased the value of our long-lived asset which we are deprecating, we must add back the portion which we depreciated due to interest (to EBIT)
Let’s say we capitalized 50m on construction interest
EBIT : 900m
Interest Expense : 150m (doesn’t include our 50m of construction interest)
This 11.68 is the result of not capitalizing interest. A better way to put it; 11.68 is the result of adjusting your interest coverage ratio to include your once capitalized interest (which is now no longer capitalized).
Just to clarify - Basically we are looking at ICRatio as if we did not capitalize interest (by adjusting the ratio by adding back the depreciation and interest expense) to show the full picture of how well the company covers its interest payment obligations. So technically, when the problem solutions states “without adjusting for interest capitalisation”, this is equivalent to saying “the Interest coverage ratio in its capitalised interest state is…etc etc”.
Yes, that’s how I’d treat it. That’s just a plug-n-your-numbers from your income statement into the Interest Coverage formula at that point – no adjustments needed.
