INTM578110 - Thin capitalisation: interest cover
Other measures of interest cover
There are measures of interest cover besides the more common
Earnings Before Interest and Tax (EBIT – see
INTM578050) and Earnings Before
Interest, Tax, Depreciation and Amortisation (EBITDA – see
INTM578060). Although they differ in
the way they calculate the measure of interest cover, the aim is
always the same: to obtain some idea of the ability of the borrower
to service the debt and to be quite clear about what is being
measured and why. It is therefore important not to become too fixed
on the method itself, but rather to look at the results in the
light of the likely attitude of a third-party lender.
The following methods of calculating interest cover may be
encountered, although they are less common than EBIT or EBITDA.
EBIT with netting of interest payable with interest receivable
HM Revenue & Customs does not generally agree to the netting
off of interest in the thin capitalisation agreements it negotiates
with groups.
It has been suggested, for example, that when calculating
interest cover it is valid to net interest receivable against
interest payable. Consider the following figures:
| 2002 | ||
| £m | ||
| Turnover | 61.50 | |
| Cost of sales | 15.70 | |
| Gross profit | 45.80 | |
| Administrative expenses | 20.70 | |
| Operating profit | 25.10 | |
| Interest receivable | 2.35 | |
| Interest payable | 7.64 | |
| Profit on ordinary activities before taxation | 19.81 | |
| Tax on profit on ordinary activities | 3.52 | |
| Profit for the financial year | 16.29 |
The value for EBIT purposes is 16.29 + 7.64 – 2.35 +
3.52 = £25.10m
Taking interest payable on its own, the interest cover is
25.10m/7.64m = 3.29
With interest receivable and payable netted, the ratio is
25.10m/(7.64m-2.35m) = 4.74
The difference is significant, although in this particular
case there may be adequate interest cover using either method.
There are two questions here, however;
- does the ratio of 4.74 reflect better than 3.29 the cover and ability to service the debt and,
- if the loan is continuing beyond 2002, what is likely to happen in future years?
These questions give rise to others:
- To what extent is the capital source of the interest receivable a permanent feature of the company’s finances, and how is it likely to vary with time?
- Is the capital source closely linked to the debt giving rise to the interest payable? For example, is it a deposit with the lender with an explicit first call on it in the event of default on the debt?
- Why did the borrower borrow so much when it already had a source of funds?
Experience has shown that third-party lenders are cautious about allowing the netting of interest receivable and interest payable when making interest cover calculations. If they do so, they require higher interest cover ratios in their agreements and impose conditions relating to the funds generating the interest receivable. The overall deciding factor is the actual ability of the company to service its debt.
EBITDA with netting of interest payable with interest receivable
Bearing in mind that EBIT and EBITDA measure different things, the same arguments apply to interest netting using EBITDA as to EBIT (see above). The only other point to add is that since the use of EBITDA generally produces higher interest cover figures that when EBIT is used (see INTM578060), it is even more important to ensure that the interest cover figures arrived at really do reflect the real ability of the borrower to service the debt.
