Can someone please help me make sense of this. It’s been taken from the first problem in Reading 42, bi) : Earnings coverage = (Pretax income + Interest expense + Amortization of capitalized interest) / (Interest expense + Capitalized interest). In essence, they’re asking for EBIT / Interest expense, but adjusted to account for the fact that the firm had always expensed interest as incurred. What I don’t understand is why the denominator is the sum of interest expense and capitalized interest instead of interest expense and amortization of capitalized interest. I thought the amortization of capitalized interest is the actual expense, and that seems to make sense in the numerator… Explanation anyone? Thanks
The above is the adjustment made in the Interest Coverage for any Interest Expense that is capitalised. For this we need to treat the capitalised interest as interest expense
Hey Guys, Are you talking about Interest Coverage or Earnings Coverage. I thought EBIT/Interest Expense is Interest Coverage. Thanks. Malek
I’m referring to EBIT/Interest Expense. (well the question says earnings coverage, but the solution effectively uses the above formula- now I’m confused- are these the same thing?) In response to reema: I understand that an adjustment is being made, but what I don’t understand is why the numerator adds only the amortized portion of capitalized interest in calculating EBIT, while the denominator adds the full capitalized interest amount in calculating interest expense. Shouldn’t this be consistent, i.e., either add the full capitalized interest in the numerator, or add only the amortized interest in the denominator, but not both? Thanks
Sales -COGS ------- Gross Profit -Depreciation(includes amortization of Captalised Interest for this period) ------- EBIT -Interest ------- EBT For Expensed Interest Interest Coverage = EBIT/Interest or =(EBT+Interest)/Interest Now since the firm has capitalised some interest so the amortised part which was deducted from the Gross Profit needs to be added back…on the same lines as we added back the Interest. This will give figure before any interest was accounted for. Then divide by the total interest liabilty(Interest expense + Capitalized interest) that the firm has. that gives the equation: interest coverage = (Pretax income + Interest expense + Amortization of capitalized interest) / (Interest expense + Capitalized interest). I hope that helps.
Ahh, so basically we use the full capitalized interest in the denominator because EVENTUALLY the unamortized portion will also be expensed, so the full capitalized amount is treated is interest, whereas the numerator only considers the current period expenses (amortization) for EBIT. That makes a little more sense intuititvely, although still confusing when you look at it strictly from a “EBIT/Interest Expense” perspective. Thanks