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.
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.
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.
can you just clafiry, i am reading from the comments:
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?
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.
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.
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?
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)