Page 128 - DMGT403_ACCOUNTING_FOR_MANAGERS

Unit 6: Financial Statements: Analysis and Interpretation

Since the ratio is 1:1, it shows that the firm raises the long term funds utilises them only for the Notes
acquisition of long term assets of the enterprise.

Coverage Ratios

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 firm.

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 firms.
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 profits
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

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