this looks very much like schweser. they may have given you a good summary, but unless you internalize what is going on here just memorizing this is going to STUMP you on the exam day. speaking from experience.
also try to assess how going back and forth between ops lease vs fin lease, how do they affect your Cash flow, taxes, ratios, etc. that’ll give you a firm handle. i’d hit the book cuz I myself have no clue how to do these.
I would actually add the interest on finance lease to the denominator as is constitutes a fixed obligation as ony other interes on long term debt and is on operatin outflow. I recall doing one example where interest coverage ratio had (EBIT + rental expense - dep) in nominator and (interest expense + interese from finance lease) in denomiator.
I am not quite sure about capitalizing interest expense, because on the CFAI EOC problem 8 (Book 2, pages 99 & 102) they say that interest coverage ratio doesn’t change by capitalizing interest expense because it is based on interest payments and not expense. Can anybody who is 100% sure about difference between capitalising vs. expensing and it’s impact on EBIT/interest explain this better.
When capitalized interest is converted back to expense, interest coverage ratio would be lower. The idea is very simple, a lump sum equals to the sum of capitalized interest is added back to the interest expense because this lump sum is supposed to be expensed as incurred. On the other hand, related depreciation is added back to EBIT because capitalized interest are allocated to dep exp or COGS in the subsequent years. In the case when the interest is expensed as incurred, this depreciation would not have occurred. Therefore, to reverse the affect of capitalization, depreciation —> EBIT.
Do you know where does the interest come from? It comes from the process of constructing an asset, and it’s a cost. Even if it is a payment, it is payable to others, and doesn’t change the fact that it is a cost. Wording problem, no big deal.
I was wondering something along similar lines, and the discussion above didn’t fully clear it up for me.
Schweser notes say that capitalizing interest improves the interest coverage ratio because it reduces income expense(the denominator).
EOC q’s from the cfa books indicate that the interest coverage ratio is unnaffected by capitalizing interest instead of expensing it because the interest coverage ratio is calculated by as EBIT/interest payments(instead of interest expense)
In this situation I’m guessing you should put your faith in the official books instead of Schweser and do so for all other conflicts?