Page 202 - DMGT202_COST_AND_MANAGEMENT_ACCOUNTING

Unit 11: Ratio Analysis

11.5.4 Coverage Ratios Notes

These ratios are computed to know the solvency of the firm in making the periodical payment
of interest and preference dividends. The interest and preference dividends are to be paid
irrespective of the earnings available in the hands of the firm. In other words, these are known as

fixed commitment charge of the fi rm.
Interest Coverage Ratio

The firms are expected to make the payment of interest on the amount of borrowings without
fail. This ratio facilitates the prospective lender to study the strength of the enterprise in making
the payment of interest regularly out of the total income. To study the capacity in making the
payment of interest is known as interest coverage ratio or debt service coverage ratio.
The ability or capacity is analysed only on the basis of Earnings Before Interest and Taxes (EBIT)
available in the hands of the fi rms.
Greater the ratio means that better the capacity of the firm in making the payment of interest as

well as greater the safety and vice versa.
Earnings before Interest and Taxes
Interest Coverage Ratio =
Interest
Lesser the times the ratio means that meager the cushion of the firm which may lead to affect the

solvency position of the firm in making payment of interest regularly.

Example: Mr Ashmit Ahuja had an earning of ` 3,00,000 before he paid the interests
and taxes. What will be the interest coverage ratio if he pays ` 30,000 as an interest? What will it
mean?

Solution:
Earnings before Interest and Taxes 3,00,000
Interest Coverage Ratio = = = 10 : 1
Interest 30,000
Since the interest coverage ratio is substantially high, it means that Mr. Ahuja has quite a good
capacity in making the payment of interest and has a high safety.

Dividend Coverage Ratio

It illustrates the firms’ ability in making the payment of preference dividend out of the earnings

available in the hands of the firm after the payment of taxation. Greater the size of the profi ts after
taxation, greater is the cushion for the payment of preference dividend and vice versa.

The preference dividends are to be paid without fail irrespective of the profits available in the
hands of the firm after the taxation.

Earnings after Taxation
Dividend Coverage Ratio =
Preference Dividend
Example: Hindustan Manufacturers have to make a preference dividend of ` 60,000.
The earnings after taxation is ` 3,00,000. What will be the Dividend coverage ratio? What does it
mean?
Solution:

Earnings After Taxation 3,00,000
Dividend Coverage Ratio = = = 5:1
Preference Dividend 60,000

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