Question

One criticism of the interest and fixed charges coverage ratios as measures of long-term solvency risk is that they use earnings rather than cash flows in the numerator. Detail how the interest coverage ratio and fixed charges coverage ratio are calculated. In addition, discuss why using earnings in the numerator is a problem and what method could be used to alleviate this problem.

Answer 1

Interest coverage ratio :

It is ratio which determines company's ability to meet its interest obligation. It is calculated by dividing company's earning before interest and tax by interest expenses. It shows company solvency strength and how many times company is able to meet its interest liability.

Formula :- Earning before interest and tax/interest expenses

problem in taking earning as numerator :

There are some variation in calculation of interest coverage ratio. Some companies are taking earning before interest, tax, depreciation and amortization as numerator. This indicates higher interest coverage ratio as denominator interest expenses is same in both Formula. Some of companies using earning before interest and after tax as numerator.By deducting tax charges company is trying to show more accurate company's ability to meet its interest obligation.

Fixed charges coverage ratio:-

Fixed charges coverage ratio indicates company's long term interest obligation. When company issue Debentures then company has to pay interest with fixed interest rate. It's company long term liability.

Formula for calculation of fixed charges coverage ratio

Earning before interest and tax/fixed charges

so it is calculated by dividing company's earning before interest and tax by fixed charges. It indicate how many times company is able to meet its fixed charges on debentures and long term loan.

problem in taking earning as numerator :

there are also vaiations in calculation of fixed coverage charges. Some company taking earnings before interest but after tax and some are taking earning before Interest, tax, depreciation and amortization. This will not show company 's accurate position to meet its long term obligations.

Following method can be taken into consideration for calculation of interest coverage ratio and fixed charges coverage ratio :

In place of taking earnings before interest and tax as numerator we should take actual cash flow of company during that period of time before paying interest and fixed charges .It will indicates actual cash receipt for the period of time and out of that how much interest and fixed charges company has to pay.