For anyone who took the CFA mock, I’m stuck on question 57 in the pm session. The answer is A - debt-equity is higher but interest coverage is not. I agree that the debt-equity ratio is higher, but how can you be sure of the impact on the interest coverage ratio without knowing the unadjusted coverage ratio? On an adjusted basis, EBIT (numerator) would increase by the total amt of the lease payments (add back rent exp) and interest expense (denominator) would increase by a fraction of the lease payments. So with an adjustment to the numerator and denominator, how do you know the impact (up, down, neutral) without knowing the unadjusted coverage ratio? What am I missing?
My best guess is that the increase to EBIT would have less of an effect than the increase in interest expense from the lease payments, unless the Company had a totally out of whack interest coverage ratio. Assume the EBIT / Interest Expense is larger than 1.
Oh and also depreciation expense would be baked into EBIT so the full rental expense amount wouldn’t be added back, only the portion that goes to interest expense. Would be a different story if CFAI considered interest coverage as EBITDA / Interest.