The objective of
these ratios is to assess the ability of the
firm to meet the financial contractual obligations
linked with debt. We select 2 coverage ratios.
Interest-coverage
=
|
EBIT |
|
Interest
expenses |
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here to see the source of data
Starworld
Group |
2021 |
2022 |
2023 |
| EBIT |
478 |
676 |
1042 |
| Interest expenses |
42 |
33 |
21 |
| Coverage |
11.38 |
20.48 |
49.62 |
This ratio relies on a basic
implicit assumption, i.e. that the company
can always roll over its maturing obligations
by taking out new loans as it repays old ones.
That is why we add a second
coverage ratio which includes as financial
obligation not only the interest expenses
but the part of debt principal amount to be
repaid during the period.
| Total
Coverage = |
EBIT |
|
| Interest
expenses + |
Principal
repayments of the period |
| |
|
(1
- tax rate) |
Let's assume a
company borrows 1000, bearing an interest
rate of 10 % and to be repaid with 5 years
in 5 equal instalments.
EBIT |
300 |
500 |
Interest
expenses |
- 100 |
- 100 |
EBT |
200 |
400 |
Tax 50
% |
- 100 |
- 200 |
Net profit |
100 |
200 |
We can clearly see that in order
to cover the total burden of our debt, we
would have to generate an EBIT of 500 so that
after deducting the interest expenses of 100,
we would be left with an EBIT of 400, 200
of which would go to taxes and the other 200
would be available to face the principal repayment.
This second ratio appears to
be more realistic than the first one but it
relies on a basic implicit assumption, i.e.
that the company will repay its existing debt
down to zero. In that sense, it may often
be too drastic.
It is therefore logical to
conclude that the Interest-coverage ratio
is too liberal, since it assumes a complete
and permanent roll over of all the company
debt obligations as they mature and the total-coverage
ratio is too conservative or drastic since
it assumes a total payment by the firm of
all its existing debt down to zero. This means
that both ratios have to be closely and carefully
analysed, since it is clear that a company
failing to meet an interest payment and /
or a principal repayment can be forced by
its creditors into bankruptcy.
Sources :
Interpreting
and using financial statements, 1999,
Marc Bertonèche, Ph. D. in Finance
from the Northwestern University, Professor
at the Bordeaux University and at Sciences-PO
Paris, Visiting Professor at Harvard Business
School and Oxford University.
© Bernard Jaquier, Professor Emeritus & Dr Honoris Causa, Ecole Hôtelière de Lausanne, 2024
