# Capitalizing interest cost on INTEREST COVERAGE RATIO

If i capitalized the interest cost instead of expensing…

EBIT/ Interest payments

If I expense, my ebit is lower and my ratio is lower = bad!

if i capitalize, wouldn’t my ratio be higher? since only depreciation hits EBIT, also, we have less interest payments?

why is it unchanged?

Capitalised interest appears on the balance sheet as part of the asset being constructed instead of being reported as interest expense in the period incurred. However, the interest coverage ratio should be based on interest payments, not interest expense (earnings before interest and taxes/interest payments), and should be unchanged.

just because a company capitalized interest payments, does not mean they didn’t have to make those interest payments. The point of the ratio is to measure EBIT over all interest payments (regardless if they were treated as an expense, or capitalized). Hence, the ratio does not change.

If you expense interest, EBIT is NOT lower…

Earnings Before INTEREST and Taxes

EBIT will not be lower if you expense. Since there will be no depreciation. If you capitalize then EBIT will be lower coz of the depreciation charge. But at the same time Interest expense (Denominator) will be lower under capitalization. So the ratio will be higher under capitalization.

Paulian, you’ve thrown me a curve ball…I thought with ICR, it should be based on Total Interest OWED and not just the Interest Expense stated. So wouldn’t the Interest be the same whether it is capitalised or not?

When I do this, I think of dip- Depreciation added, Interest added. Lease Payment removed If I’m missing something, let me know Depreciation value depends on how you calculate it, but if npv < lease payments and both straight, then I’m thinking ebit will be slightly lower, but usually interest will have the bigger gain so the ratio will reduce. When it is expensed, there is no interest. No asset, no depreciation for this project. We simply paid for it with cash like a rental expense.

You are right! I was thinking of LEASE PAYMENTS! not capitalized interest! ( DARN ITS 130AM)

OK! *** IF WE DEFINE INTEREST COVERAGE AS EBIT/ INTEREST PAYMENTS *** NOT INTEREST EXPENSE

• Not capitalizing the interest expense will increase my interest expense and lower my ratio!
• If I capitalize it!!! I’m still ****paying cash interest**** this is **KEY**
• YOU ARE STILL PAYING CASH INTEREST, WHETHER YOU CAPITALIZE OR EXPENSE
• HOWEVER, IF YOU CAPITALIZE, YOUR ASSET INCREASE…BUT YOU STILL PAID CASH INTEREST EXPENSE!

GOT!

GRACIAS!

PAULINA!

got it!!! cash interest was paid regardless if i capitalize or expense!

WONDERFUL!

Hi,

slightly confused with the above as one comment says capitalisation higher then another says unchanged etc. or i might be just missing the obvious with lack of sleep.

Interest Coverage, EBIT/ TOTAL INTEREST PAYMENTS, under Capitalisation of interest is higher versus expensing due to higher EBIT

demoninator stays same for both as interest payments whether capitalsed or expensed are still to be paid.

CFAI states- after adjustments the ratio remains unchanged. can someone just reiterate why EBIT is not higher under capitalisaiton and thus the ratio higher?

sorry for dragging this out!

I’m confused as well. I agree the denominator is same under both methods (capitalizing vs expensing).

However if we capitalize we shall depreciate => EBIT will be lower => interest coverage ration will be lower (before adjustments).

Rasec , where did you get from the quote that says Interest coverage ratio is same under both approaches?

If we adjust Capitalized interest to compare it with expensing : Adjustment 1) EBIT-Depreciation 2) Add the interest to interest expense. Obviously after adjustment ratio will be same.

I’m saying the same thing but in the original post it’s not mentioned that the ratios will be same after adjustments, only that they are the same. That’s why I want the source.

Yea the original post mentioned it erroneously i guess!

Again, for clarity-

Before any adjustment, capitalisation of interest results in a lower interest coverage ratio versus expensing.

due to the lower EBIT as a result of dprn in numerator. denominator stays constant throughout.

When adjusting EBIT-dprn/interest + interest expense. ratio remains same…think ive got it.

if not…maybe i’ll just remember they remain unchanged then figure out why on 7th June!

All Messed up to be honest!

My understanding is In Capitalisation We have low EBIT (coz of dep charges) and low interest expenses (coz we dont expense interest out from Interest Expense … we do it through Dep exp). Resulting in a higher ratio.

After adjustment : We remove depreciation from EBIT and add capitalised interest to the interest expense. Resulting in lower coverage ratio.

PLEASE CORRECT ME IF I AM WRONG HERE!

This is my point and why Rasec began the thread ( i assume). The ratio should become higher (due to increased EBIT) however CFAI stays the ratio remains unchanged after adjusting.

I agree the denominator will stay the same, as by definition of the interest coverage ratio, EBIT/interest payments, interest payment will include interest expense regardless of classifaction but my issue is with EBIT.

my logic- under expensing EBIT is lowest as whole expense hits EBIT compared to just depreciation under capitalisation. therefore why is the ratio unchanged rather than higher under cap?

The denominator for Interest coverage ratio is interest payments , not interest expenses.

im assuming interest expense is included in interest payment… i.e. summing them both together.

we need S2000 To explain why the ratio remains unchanged… (according to CFAI)

I’m wondering if we may be talking about two different things here. Capitalizing an expense lease and capitalizing interest? (This perhaps was my fault because I was doing a lease problem before responding. ) If we’re talking about capitalizing interest , then why would interest have depreciation?

I’m wondering if we may be talking about two different things here. Capitalizing an expense lease and capitalizing interest? (This perhaps was my fault because I was doing a lease problem before responding. ) If we’re talking about capitalizing interest , then why would interest have depreciation?

Ok read the excerpt below you will understand hopefully…

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)

Dep of Capitalized Interest : 10m

Therefore we would calculate…

900m + 10m / 150m + 50m = 910 / 200 = 4.55