ShmoopTube

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finance a la shmoop- what is the times covered interest ratio?

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okay people. we'll just restate the question if it's simpler. from your [girl frowns in classroom]

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operating profits this part of your income statement right here- how many

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times is your interest expense covered? still not simple enough? okay how about

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this? how big a multiple is your operating

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profit of your interest cost? there we set it boom. okay so you run furry nation [definitions listed]

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America's finest purveyor of animal bodysuits. the company has two billion

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dollars in debt on which you pay six percent interest or 120 million dollars

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a year. you really wanted that platinum encrusted fidgets spinner and well you

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just couldn't wait. furry nation has revenues of three billion dollars and [hand spins fidget spinner]

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conveniently has operating profits of 360 million. so how many times larger is

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your operating profit than your yearly interest? well check out the hundred

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twenty million dollars error of interest from before, that number gets divided

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into the operating profit number. and the answer? three. well why does this ratio [equations]

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matter? well the three times interest covered number is a solid indication of

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how easily you can pay the interest if not the principle of the debt you have

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borrowed. think about a normal boom and bust business cycle. in a bad year your [bridge blows up]

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company might shrink to have only two billion of revenues and 180 million

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dollars of operating profits. in which case in that dismal year it would have

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only one point five times interest coverage. in a great year with say 900

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million of operating profit while the coverage ratio would be 6x or 600 [equations]

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percent or six times. now put your butt in the seat of the lender. if you're the

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one who loaned the two billion dollars at 6% while you're getting pretty

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nervous about being able to collect your money back when operating profits are

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down to just one point five times. but it's six times interest well you sleep [woman snores in bed]

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like a baby happy to keep collecting your interest payment though. so why do

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we use operating profits this line here instead of net income or after-tax

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profits this line here when we calculate the times interest ratio? well because

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interest costs are tax-deductible? they're a cost just like [definitions]

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plastic or office building rent or mandatory company yoga retreats. the cost

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of renting money is treated for tax purposes really no different from the

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cost of renting a building. so we don't worry about taxes when we're focused on

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just repaying our debts. just don't try to use that excuse when tax time comes [woman smiles behind desk]

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around though. Uncle Sam well he don't play.

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