INTM578130 - Thin capitalisation: interest cover
Example of an interest cover calculation
Consider the following extract from a profit & loss account.
| Note | 2003 | ||
| £m | |||
| Turnover | 161,550 | ||
| Cost of sales | 1 | 115,760 | |
| Gross profit | 45,790 | ||
| Administrative expenses | 2 | 20,680 | |
| Operating profit | 25,110 | ||
| Interest receivable | 3 | 4,314 | |
| Interest payable | 7,642 | ||
| Profit on ordinary activities before taxation | 21,782 | ||
| Tax on profit on ordinary activities | 4,574 | ||
| Profit for the financial year | 17,208 |
Notes:
- Cost of Sales includes the following items:
- Depreciation on plant & machinery £11,430m. Capital expenditure on plant & machinery during the year was £8,420m.
- Amortisation of goodwill was £3,450m, relating to the acquisition three years ago of a rival business. The acquired business has proved to be profitable, with a number of cost savings relating to economies of scale.
- In July 2002 the company acquired an intangible asset which is subject to the provisions of FA02/SCH29 (gains & losses of a company from intangible fixed assets). Amortisation of the intangible is over a ten-year period, and the figure for 2003 is £300,000.
- Interest receivable is generated mainly by the placement of surplus operating cash on the overnight money markets.
In the light of the above information, a calculation of the interest cover (as a measure of cash- flow) for 2003 might proceed as follows:
| Item | Comment | Amount included in calculation of interest cover (£m) |
| Depreciation on plant & machinery | Although this is not a cash item, the replacement of plant & machinery is an important feature in the company’s business, as shown by the amount spent in the year on new equipment. Generally, it is better to stick with the audited figure of depreciation, but in unusual circumstances a third party lender may be prepared to allow the add-back of depreciation, but take into account the capital expenditure of the year. |
Add back £11,430m and deduct £8,420m |
| Amortisation of goodwill | Although this payment (for the acquired business over and above the value of the tangible assets) was a cash payment in a previous year, it is not a cash payment in this year. In addition, the profitability and cost savings relating to the acquired business are likely to offset the amortisation costs. |
Nil |
| Amortisation of intangible asset | A non-cash item that can be added back. However, any future impairment reviews that are reflected in the Profit & Loss Account would give a third-party lender pause for thought about the future profitability of the company. |
Nil |
| Interest receivable | There is no support for any contention that interest receivable should be netted against interest payable | Interest receivable should not be netted against interest payable, but if there is an indication that there is some interest received each year, then consideration can be given to the effect of adding the interest receivable to the profit figure. |
On the basis of the above comments, the interest cover figure
is calculated as follows:
Income available in 2003 = 17.208 + 4.574 + 7.642 + 11.430
– 8.420 + 3.450 + 0.300 – 4.314 = £31.87m
Interest cover = 31.87/7. 642 = 4.17
(If netting of interest receivable with interest payable had
been allowed, the interest cover would have been 9.58.)
