Impact of Capitalization of Interest instead of Expenseing on EBIT Coverage Ratio

CFA Level II
#1

Does Capitalization of Interest instead of Expenseing would result an increased EBIT Coverage Ratio ?

If yes, then why not option A of EOC 8 (Reading#17) should not be treated as correct? The curricullum says that option B is correct; which I agree.

Please Clarify.

#2

They explain it pretty clearly.

  • No effect on EBIT or Revenue – same numerators
  • Denominator of Interest Coverage Ratio is not the recorded interest expense; it’s the actual cash interest paid. So capitalizing doesn’t change that ratio at all.
  • Capitalized interest is recorded with the fixed asset the interest is paying for (in this case, the interest on a mortgage to build a factory). Higher fixed assets means lower fixed asset turnover.

Interest Coverage Ratio uses actual interest payments instead of any fancy accounting trickery because it’s supposed to tell you the company’s ability to cover its loan payments – to avoid default. Regardless of how the chief financial officer wants to accrue interest, s/he still has to pay it – or else (*slides finger across neck*).