INTM577010 - Thin capitalisation: interest cover - debt servicing: What interest cover means

A company’s interest cover is often regarded as a measure of its ability to service its debt, to pay the interest and possibly other costs associated with borrowing. It is a calculation of the number of times the profits of a company can “cover” its interest expense, and this measure frequently serves as one of the mainstay covenants in a thin capitalisation agreement.

The basic calculation is as follows:

This shows how many times the profits for the period can cover the interest charge for the period. For example, if the profit per the accounts before interest (payable or receivable) and tax is £12m and the interest payable is £3m, the EBIT (Earnings Before Interest & Tax) interest cover will be 4:1. It gives some indication of the ratio of the available cash to the interest payable.

Further adjustments may be made to bring the profits figure closer to a cash flow measure - most commonly by adding back the deductions for depreciation and amortisation, both of these being frequently significant non-cash deductions, in arriving at operating profits. This is called Earnings before Interest, Tax, Depreciation & Amortisation or EBITDA, and has become a popular measure in third-party and therefore in thin cap agreements, since it approximates to cash flow. If in the example above, non-cash items in the accounts totalling £2m are added back to the profit (i.e. their deduction is cancelled out), the ratio becomes 14:3, i.e. the EBITDA:interest cover will be approximately 4.6:1.

Please note that ratios are illustrative, not indications of broadly acceptable (or unacceptable) ratios.

Different ways of calculating the accounts profits for thin capitalisation purposes are discussed from INTM577030 onwards.

The term ‘income cover’ is often encountered, and is usually regarded as interchangeable with ‘interest cover’. However, the latter may be used to refer to the “cash” position (EBITDA) rather than the accounts figures (EBIT).

The most important measure to a third-party lender is the cash-flow position. Cash flow is discussed in more detail at INTM577140. A lender is primarily interested in the ability of a borrower to service debt, not with accounting adjustments, and a cash flow measure demonstrates that ability without the sometimes significant distortion caused by accounting policies. Where a group does not prepare a consolidated cash-flow position, for example because it is part of a larger group, then interest cover based on the operating profit shown by the profit & loss account may be considered an acceptable substitute. In such a case, however, it is important to have a good understanding of the accounting policies used, in order to appreciate how far the account’s operating profit is from the business cashflow.

A business can falter or fail even when it is profitable, because it has liquidity problems - a shortage of cash.

There is a problem, though, with eliminating purely accounting adjustments and focusing too exclusively on cash, since accounting entries such as depreciation can represent significant future expenditure, and the accounts deduction is making provision for that future expense. This will be discussed in this chapter at INTM577070.