Definition:
The ratio measures debts servicing capacity of
a business so far as interest on long-term loans is concerned. This ratio shows
how many times the interest charges are covered by the earnings. Debt
service ratios is also know as interest coverage ratio.
Formula:
The ratio is calculated with following formula:
Debt service ratio = Earnings
before interest and taxes (EBIT) / Fixed interest charges
Example:
From the following, calculate interest coverage
ratio.
| |
$ |
| 9% Mortgage loan |
10,00,000 |
| 7.5% Debentures |
12,00,000 |
| Net profit (after tax) |
9,72,000 |
| Income tax rate |
50 % |
Solution:
Interest coverage ratio =
Earnings before interest and tax / Fixed interest charges
= 21,24,000*
/ 1,80,000**
11.8 times
Working:
(i) Calculation of Interest
Payable:
(l0,00,000 × 9 /
100 ) + (12,00,00 ×
15 / 2 ×
1 / 100)
90,000 + 90,000
= $1,80,000**
(ii) Calculation of Tax
Liability:
Tax rate = 50%
Profit after tax = 972,000
Tax amount = [9,72,000 / (100 -
50)] x 50
= 9,72,000
(iii) Profit before Interests
and Tax:
= Profit after tax + Tax +
Interest
= 9,72,000 + 9,72,000 + 1,80,000
= 21,24,000*
Comments:
Net profits available for payment of interest
are approximately 12 times. It implies that even if earnings decline to 1/11th
of the current figure long-term creditors interest repayments is safe. |
