Hello everyone,
“Alpha’s decision to capitalize its interest costs instead of expensing them results in a lower fixed asset turnover ratio and a higher interest coverage ratio.”
In the statement, “lower fixed asset turnover” is true, but “higher interest coverage ratio” is false. The answer sates, “the interest coverage ratio should be based on interest payments, not interest expense (earnings before interest and taxes/interest payments), and should be unchanged.”
My question is, is that true? If capitalize interest (or any other means to increase/decrease interest expenses), would interest coverage ratio stay unchanged? Thanks!
Reference: CFAI Reading 29 Practice Problems Q30
The book answer is right.
Debt Service is said to be Interest + Amortization of Debt. In simple words: the monthly payment of your loan. Note that bonds have commonly 0 dollar amortization (Bullet Bonds) so debt service in this case is just Interest.
Interest is the cost of borrowed money and is paid in full to debt holders in form of cash. It is an obligation (you can’t reduce interest payments unless you restructure your debt, which is bad at the eyes of investors, so no).
The interest coverage ratio is built in the assumption of assessing if the company can “cover” this obligation with its operative income (or EBITDA, because depreciation and amortization are provisions, not cash), so the ratio is most accurate calculated as the following:
EBIT (or EBITDA) / Interest Payments
The book states Interest Expense because in real life Interest Expense equals Interest Payments most of the time. There are a few valid cases when you can capitalize interest expenses.
In the case a company capitalizes part or total of interest expenses from debt, this company is obliged to disclosure this information treatment in the Notes of its Financial Statements (FS). Therefore, the financial analyst is most likely to adjust the Interest Expense showed in the Income Statement by adding the capitalized interest expense showed in the relevant FS note at the moment he/she is meant to calculate Interest Coverage Ratio.
Hope this helps!
EBIT = No effect from capitalizing.
Interest Expense = Lower than if you expensed.
that in itself will result in higher ratio.