What will be the Interest Coverage Ratio, when 20% Long Term Debt is ₹10,00,000, Tax Rate 40%, and Net profit after tax is ₹6,00,000?
6 Times
Let's calculate the Interest Coverage Ratio based on the information provided. The Interest Coverage Ratio is a crucial solvency ratio that measures a company's ability to pay interest expenses on its outstanding debt. It is calculated using the formula:
\[ \text{Interest Coverage Ratio} = \frac{\text{Earnings Before Interest and Tax (EBIT)}}{\text{Interest Expense}} \]
To use this formula, we first need to determine the Interest Expense and the Earnings Before Interest and Tax (EBIT) from the given data.
Understanding the Given Financial Information
- Long Term Debt: ₹10,00,000
- Interest Rate on Debt: 20%
- Tax Rate: 40%
- Net Profit After Tax (NPAT): ₹6,00,000
Calculating Interest Expense
The interest expense is calculated as the percentage interest rate applied to the long-term debt amount.
\[ \text{Interest Expense} = \text{Long Term Debt} \times \text{Interest Rate} \]
\[ \text{Interest Expense} = \text{₹}10,00,000 \times 20\% \]
\[ \text{Interest Expense} = \text{₹}10,00,000 \times 0.20 \]
\[ \text{Interest Expense} = \text{₹}2,00,000 \]
So, the interest expense for the period is ₹2,00,000.
Determining Earnings Before Interest and Tax (EBIT)
We are given the Net Profit After Tax (NPAT). To find EBIT, we need to work backward through the income statement.
First, let's find the Profit Before Tax (PBT). The relationship between NPAT, PBT, and Tax is:
\[ \text{NPAT} = \text{PBT} - \text{Tax} \]
Since Tax is calculated as a percentage of PBT, we have:
\[ \text{Tax} = \text{PBT} \times \text{Tax Rate} \]
Substituting this into the NPAT formula:
\[ \text{NPAT} = \text{PBT} - (\text{PBT} \times \text{Tax Rate}) \]
\[ \text{NPAT} = \text{PBT} \times (1 - \text{Tax Rate}) \]
We know NPAT is ₹6,00,000 and the Tax Rate is 40% (or 0.40).
\[ \text{₹}6,00,000 = \text{PBT} \times (1 - 0.40) \]
\[ \text{₹}6,00,000 = \text{PBT} \times 0.60 \]
Now, we can solve for PBT:
\[ \text{PBT} = \frac{\text{₹}6,00,000}{0.60} \]
\[ \text{PBT} = \text{₹}10,00,000 \]
Profit Before Tax is ₹10,00,000.
Next, we know that PBT is calculated as EBIT minus Interest Expense:
\[ \text{PBT} = \text{EBIT} - \text{Interest Expense} \]
We have calculated PBT as ₹10,00,000 and Interest Expense as ₹2,00,000. We can now find EBIT:
\[ \text{₹}10,00,000 = \text{EBIT} - \text{₹}2,00,000 \]
Rearranging the formula to solve for EBIT:
\[ \text{EBIT} = \text{₹}10,00,000 + \text{₹}2,00,000 \]
\[ \text{EBIT} = \text{₹}12,00,000 \]
Earnings Before Interest and Tax is ₹12,00,000.
Calculating the Interest Coverage Ratio
Now that we have EBIT and Interest Expense, we can calculate the Interest Coverage Ratio:
\[ \text{Interest Coverage Ratio} = \frac{\text{EBIT}}{\text{Interest Expense}} \]
\[ \text{Interest Coverage Ratio} = \frac{\text{₹}12,00,000}{\text{₹}2,00,000} \]
\[ \text{Interest Coverage Ratio} = 6 \text{ Times} \]
The Interest Coverage Ratio is 6 Times. This means the company's earnings before interest and taxes are 6 times its interest expense, indicating a strong ability to meet its interest obligations.
| Item | Calculation | Amount (₹) |
|---|---|---|
| Long Term Debt | Given | 10,00,000 |
| Interest Rate | Given | 20% |
| Interest Expense | $10,00,000 \times 20\%$ | 2,00,000 |
| Net Profit After Tax (NPAT) | Given | 6,00,000 |
| Tax Rate | Given | 40% |
| Profit Before Tax (PBT) | $6,00,000 / (1 - 0.40)$ | 10,00,000 |
| Earnings Before Interest and Tax (EBIT) | $10,00,000 + 2,00,000$ | 12,00,000 |
| Interest Coverage Ratio | $12,00,000 / 2,00,000$ | 6 Times |
Revision Table: Key Financial Ratios and Calculations
| Ratio/Item | Formula | Purpose |
|---|---|---|
| Interest Expense | Principal Debt $\times$ Interest Rate | Cost of borrowing funds. |
| Profit Before Tax (PBT) | Net Profit After Tax / (1 - Tax Rate) | Profit before deducting income tax. |
| Earnings Before Interest and Tax (EBIT) | PBT + Interest Expense | Profit before deducting interest and tax; represents operating profitability. |
| Interest Coverage Ratio | EBIT / Interest Expense | Measures ability to cover interest obligations with operating earnings. |
Additional Information on Interest Coverage Ratio
The Interest Coverage Ratio is a critical measure for creditors and investors. A higher ratio indicates that a company has a greater ability to meet its interest payments, signifying lower financial risk. Conversely, a low ratio may suggest that a company is overly burdened by debt and could struggle to pay interest, especially if earnings decline.
- A ratio of 1.5 to 2.5 might be considered minimum acceptable in many industries.
- A ratio below 1 means the company is not generating enough earnings before interest and tax to even cover its interest expense, which is a serious financial health warning.
- The acceptable level for the ratio varies significantly across different industries based on their typical debt levels and stability of earnings.
- This ratio is often used in conjunction with other solvency and liquidity ratios for a comprehensive financial analysis.
Important Questions from Accounting Ratios
Calculate the amount of fixed obligation of the company.
The return on investment will be:
Earning Per Share (EPS) will be:
The Price Earning (P/E) ratio will be:
Gross Profit Ratio of a company was 25%. If credit revenue from operation was ₹20,00,000 and cash revenue from operation is 20% of total revenue. If indirect expense of the company was ₹50,000. Calculate Net Profit Ratio?
