Question

From the following details, calculate interest coverage ratio: Net Profit after tax Rs. 1,20,000; 15% Long-term debt 20,00,000; and Tax rate 40%.

• A. 1.67 times
• B. 1.75 times
• C. 1.89 times
• D. 1.95 times

Hint:

Interest coverage = (Profit before tax + Interest) / Interest. First find profit before tax from profit after tax and the 40% tax rate.

Answer 1

The Correct Option is A

Step 1: Understand the ratio.
Interest coverage ratio shows how many times the profit before interest and tax covers the interest.
\[ \text{Interest Coverage Ratio} = \frac{\text{Net Profit before Interest and Tax}}{\text{Interest on Long-term Debt}} \]
So we need profit before tax, then add back the interest to get profit before interest and tax.

Step 2: Find profit before tax.
Net profit after tax is Rs 1,20,000 and the tax rate is 40%. So profit after tax is 60% of profit before tax.
\[ \text{Profit before tax} = \frac{1{,}20{,}000}{60} \times 100 = 2{,}00{,}000 \]

Step 3: Find the interest.
Interest is 15% of the long-term debt.
\[ \text{Interest} = 20{,}00{,}000 \times \frac{15}{100} = 3{,}00{,}000 \]

Step 4: Find profit before interest and tax.
Profit before tax is struck after charging interest. So we add the interest back.
\[ \text{PBIT} = 2{,}00{,}000 + 3{,}00{,}000 = 5{,}00{,}000 \]

Step 5: Find the ratio.
\[ \text{Interest Coverage Ratio} = \frac{5{,}00{,}000}{3{,}00{,}000} = 1.67 \text{ times} \]

Step 6: Check the other options.
Options 2, 3 and 4 (1.75, 1.89 and 1.95 times) do not match 5,00,000 divided by 3,00,000. They come from wrong steps, such as forgetting to add back the interest or using the wrong tax adjustment. So only option 1 is right.

Final Answer:
The interest coverage ratio is 1.67 times, which is option 1.
\[ \boxed{1.67 \text{ times}} \]