Coverage Ratios
Lenders are interested in evaluating a company’s financial performance, to project whether the firm will be able to pay interest on borrowed funds and repay the debt when it comes due. Lenders are therefore interested in measures such as the times interest earned ratio. Lenders need to assess company plans and projections, particularly those a?ecting income from operations, to determine whether their loans to the company are at risk.
How many times of the interest payment the entity earned is phrased as Times Interest earned. Sometimes this causes confusion to the beginner as he could guess that how many times the income earned matching with interest earned (income); therefore one needs to know with a little extra care or else beginners might feel that name a misnomer.
Times interest earned = Profit before Interest & taxation/ Interest expense
Something closer to times interest earned is debt service coverage ratio. In this analysis the reader wants to know how much the entity earned cash profit to match with the instalment payment inclusive of principal (of course with interest). The formula for this debt service coverage ratio is
= Net profit after tax + Interest expense + depreciation/instalment amount (principal + Interest)
The analyst wants to know how much the entity has cash profit to service the instalment amount.
For both times interest earned and Debt service coverage ratio, higher the value (metric) better is the performance of the entity.
CA L.Muralidharan and CPA L.Mukundan
Visti www.sreeramcoachingpoint.com Contact : 63 83 22 82 0 2/ 98 44 33 97 69
