Capitalising of Interest


Can someone help me with this question? How did they get to $188 and how is interest coverage is justified?

Q. A company’s debt covenant requires it to maintain an interest coverage of 2.25; the ratio is calculated using total interest paid. The following information is taken from the company’s 2014 financial statements:

2014 $ thousands
Net sales 11,159
Cost of goods sold (COGS) 9,898
Selling and administrative expense (S&A) 872
Interest expense 122
Earnings before tax 267

Note 11: Property and Equipment (all figures in $ thousands)

Depreciation expense for 2014 is $388. This amount includes capitalized interest of $34.

Interest is allocated and capitalized to construction in progress by applying the firm’s cost of borrowing rate to qualifying assets. Interest capitalized in 2014 is $66.

Note 13: Long-Term Debt

All bonds were issued at par.

The most appropriate statement about the company’s debt covenant restriction in 2014 is that the firm:

  1. just satisfied it.
  2. failed to meet it by at least 5%.
  3. exceeded it by at least 5%.

Solution: A is correct.

($ thousands)
EBIT = Net sales − COGS − S&A = 11,159 − 9,898 − 872 = 389
Add back depreciation related to capitalized interest 34
Adjusted EBIT 423
Interest expense: Income statement 122
Add capitalized interest: Notes to financial statement 66
Total interest paid 188

The interest coverage ratio requirement has been exactly achieved.

Because the bonds were issued at par, no amortization of premiums or discounts is included in interest paid.