Why are fixed expenses added to the numerator in this ratio? Aren’t we trying to see how EBIT will be able to cover interest and other fixed payments (which are already included in the denominator)?
For the interest coverage ratio, why do we compute:
EBIT / interest expense
instead of:
EBT / interest expense
?
lol… Magician is funny…lol…
We add fixed expense to the equation because we are trying to see the strenght or how many times the company’s earnings can cover its fixed expenses, so it is logical to add back that year’s fixed expense to EBIT so as to arrive at the appriapriate metrics.
Hope that helps a little.
I wasn’t trying to be funny.
I was trying to be Socratic.
The reason we add back fixed charges into the numerator in the FCC ratio is that we need to determine the ratio of “earnings” available to pay the fixed charges to the fixed charges. If we didn’t add back fixed charges, we’d be comparing fixed charges to a number that was AFTER fixed charges.
Socratic questioning aside (and I’m a big fan of it), this is the same logic behind why we use EBIT in the Interest Coverage ratio rather than EBT - EBT is not earnings available to pay interest, as it’s AFTER interest. We use EBIT because it’s the total resources available to pay EBIT (i.e. the number immediately above it on the income statement).
Yeah that makes sense. I must have been brain fried to not see this before!