Interest coverage ratio- why based on interest payments

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afranks1

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CFAI reading 18 practice problem 8: question says they are capitalizing rather than expensing. In the answer it says “the interest coverage ratio should be based on interest payments, not interest expense (earnings before interest and taxes/interest payments), and should be unchanged.
1. If we are capitalizing, we have lower interest expense (compared to expensing), so wouldn’t interest coverage be higher, rather than unchanged?
2. Also, isn’t interest coverage EBIT/ interest expense, why are they using interest payments?
 
The view is from an analytical standpoint… You make adjustments to include all interest paid (capitalized and expensed) in the interest coverage ratio.
1. From an accounting standpoint - yes, that is correct. However, we’re not taking the CPA exams. We want to consider all the interest the company is paying.
2. At level 2, we don’t discriminate against the class of interest. We include all interest in the for an “all-encompassing” ratio.
 
afranks1 wrote:1. If we are capitalizing, we have lower interest expense (compared to expensing), so wouldn’t interest coverage be higher, rather than unchanged?
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Question: If you call a donkey’s tail a leg, how many legs does a donkey have?
Answer: Four. Calling it a leg doesn’t make it a leg.
 
Hi s2000, but I don’t get it after this explanation…
 
It doesn’t matter whether you call interest an expense or an asset; it’s still interest, so the interest coverage ratio should include it in the denominator.
 
I believe CFAI has defined Interest coverage in a way that whether it is very high or low, analyst should
investigate further reason for high/low via further income statement analysis or benchmarking.
From another angle, purpose of ratio is to analyse past and then by using this ratio analysis future earnings
can be normalised.
I believe no matter how you are calculating interest coverage ratio it will itself not represent or indicate any
thing unless supported by some other ratio and benchmarks.
 
but for any calculations of the interest coverage ratio (e.g. reading 18, pg 59 of the text), CFAI has interest coverage ratio with capitalized interest higher than interest coverage ratio with expensed interest (given the lower denominator when capitalizing).
So i don’t see why their answer is correct for practice problem 8 “interest coverage ratio should be unchanged”.
 
They provide a pretty clear explanation in the solution to question 8. “To provide a true picture of a company’s interest coverage, the entire amount of interest expenditure, both the capitalised portion and the expensed portion, should be used in calculating interest coverage ratios.” - This says when calculating a company’s interest coverage ratio, regardless of how they classify interest (as a capitalized item or an expense), the ratio should be unchanged, because, as an analyst, you are to consider ALL interest payments a company makes (both capitalized and expensed). For example, if a company has EBIT of $100 and total interest payments of $10, their interest coverage ratio is $10. If all $10 of the interest was capitalized and $0 was expensed… the ratio remains the same - 10x. If $5 of it was capitalized and $5 was expensed, the ratio is still the same… 10x. If all $10 was expensed… the ratio is still… 10x. The gist of of the point is, as an analyst, you are to consider ALL interest outlays when calculating the interest coverage ratio, regardless of what it’s categorized as, because the company still has to pay interest on the debt, whether they expense it or capitalize it means nothing to you when calculating the ratio, you should only care about total interest paid.
 
Would you look…, thanks for your explanation!
So am i correct in saying that if we consider ALL interest payments, then interest coverage will be the same. However, if we look at:
1. Interest coverage using capitalized interest; and
2. Interest coverage using expense interest,
Then the interest coverage ratios will differ when we look at them separately (given different denominators)
 
Yes, if a company reports both interest expense and capitalized interest, but you only pay attention to one or the other, your calculated interest coverage ratio will be higher than the correct interest coverage ratio that will take both of them into consideration.
 
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