Question

From the following information, calculate 'Interest Coverage Ratio':

Shareholders' funds	Rs 30,00,000
8% Long-term debt	Rs 10,00,000
Net profit after tax	Rs 2,40,000
Tax Rate	40%

Hint:

Convert profit after tax to profit before tax (divide by 60%), add the 8% interest of Rs. 80,000 to get profit before interest and tax, then divide by the interest. The answer is 6 times.

Answer 1

Step 1: Meaning of the ratio:
Interest Coverage Ratio shows how many times the profit before interest and tax covers the interest on long-term borrowings.
Formula: Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on Long-term Borrowings.
So we need two figures: profit before interest and tax, and the interest.

Step 2: Net Profit before Tax:
The tax rate is 40%, so net profit after tax is 60% of profit before tax.
Net Profit before Tax = 2,40,000 x 100/60 = Rs. 4,00,000.
Check: tax = 40% of 4,00,000 = Rs. 1,60,000, and 4,00,000 - 1,60,000 = Rs. 2,40,000, which matches the given figure.

Step 3: Interest on long-term debt:
The debt is 8% Long-term debt of Rs. 10,00,000.
Interest = 8/100 x 10,00,000 = Rs. 80,000.

Step 4: Net Profit before Interest and Tax:
Interest was charged before arriving at profit before tax, so we add it back.
Net Profit before Interest and Tax = 4,00,000 + 80,000 = Rs. 4,80,000.

Step 5: Interest Coverage Ratio:
Interest Coverage Ratio = 4,80,000 / 80,000 = 6 times.
Shareholders funds of Rs. 30,00,000 are not needed for this ratio, so we leave them out.

Final Answer:
The Interest Coverage Ratio is 6 times, so the profit before interest and tax covers the interest six times.