Interest Coverage Ratio - Interest Capitalizing

CFA Level II
#1

Schweser B.2 P36

Capitalizing interest result in a higer interest coverage ratio (smaller denominator)

Don’t really understand…EBIT/Interest expense, EBIT will be lower because of depreciation as well.

Ratio - Lower/Lower =>uncertain?

#2

Your extra depreciation expense is only part of the capitalized interest, so the numerator declines by a smaller amount, and presumably your EBIT is larger than your interest expense, so the numerator would decline by a smaller percentage even if the amounts were the same.

Try some numbers. First, without capitalizing:

  • EBIT = $100
  • Int = $10
  • Ratio = $100 / $10 = 10

Next, with capitalizing $4, assuming 4-year, straight-line depreciation:

  • EBIT = $99 (= $100 – $4 / 4)
  • Int = $6 (= $10 – $4)
  • Ratio = $99 / $6 = 16.5
1 Like
#3

Many many thanks, magician!

#4

You’re quite welcome.

#5

Just see EOC, page.106. Q8 said interest coverage ratio will be the same (Expense vs. capitalise)

Different definition?

#6

Interest capitalized and expense through depreciation is from a different period, so we add it back to EBIT and ignore.

Lower/Lower is not enough to go by. You need to know the magnitude of the changes in both the numerator and denominator to understand the full effect on the ratio.

Example: 1000 / 1 = 1000, 999 / 0.5 = 1998 (lower / lower = higher).

#7

Thanks, but EOC, page.106. Q8 said interest coverage ratio will be the same (Expense vs. capitalise)?

#8

Yeah they’re being weird for that question. They’re just saying base it off actual payments not the IS expense because payments represent the true underlying cash flow (which really matters when determining if they can pay).

For the exam know the actual calcs as we stated above.

#9

Also remember capitalizing the lease will result in lower Interage coverage ratio.

#10

if I am not mistaken, interest coverage ratio is below

EBIT/Interest payments (not expense but actual payments… which don’t change wether or not you capitalize)