You run Furry Nation, America's finest purveyor of animal body suits. The company has $2 billion in debt, on which you pay 6% interest, or $120 million a year. You really wanted that platinum-encrusted fidget spinner and just couldn’t wait.
Furry Nation has revenues of $3 billion and, conveniently, has operating profits of $360 million. So how many times larger is your operating profit than your yearly interest?
Well, check out the $120 million of interest from before. That number gets divided into the operating profit number. The answer? Three. Why does this matter? Well, the 3x Times Interest Covered number is a solid indication of how easily you can pay the interest, if not the principal, of the debt you have borrowed.
Think about a normal boom and bust business cycle. In a bad year, your company might shrink to have only $2 billion of revenues and $180 million of operating profits, in which case, in that dismal year, it would have only a 1.5x times interest coverage. In a great year with, say, $900 million of operating profit, the coverage ratio would be 6x, or 600%, or 6 times. Put your butt in the seat of the lender. If you’re the one who loaned the $2 billion at 6 percent, you’re getting pretty nervous about being able to collect your debt when operating profits are down to just 1.5x. But at 6x, well, you sleep like a baby, happy to keep collecting your interest payment dough.
So why do we use operating profits instead of net income or after-tax profits when we calculate this times interest ratio? Because interest costs are tax-deductible. They are a cost, just like plastic, office building rent, or mandatory company yoga retreats. The cost of renting money is treated, for tax purposes, really no differently than the cost of renting a building.
So we don’t worry about taxes when we’re focused on only repaying our debts. Just don't try to use that excuse when tax time comes around. Uncle Sam don't play.
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Finance: What is the Times Covered Inter...23 Views
finance a la shmoop- what is the times covered interest ratio?
okay people. we'll just restate the question if it's simpler. from your [girl frowns in classroom]
operating profits this part of your income statement right here- how many
times is your interest expense covered? still not simple enough? okay how about
this? how big a multiple is your operating
profit of your interest cost? there we set it boom. okay so you run furry nation [definitions listed]
America's finest purveyor of animal bodysuits. the company has two billion
dollars in debt on which you pay six percent interest or 120 million dollars
a year. you really wanted that platinum encrusted fidgets spinner and well you
just couldn't wait. furry nation has revenues of three billion dollars and [hand spins fidget spinner]
conveniently has operating profits of 360 million. so how many times larger is
your operating profit than your yearly interest? well check out the hundred
twenty million dollars error of interest from before, that number gets divided
into the operating profit number. and the answer? three. well why does this ratio [equations]
matter? well the three times interest covered number is a solid indication of
how easily you can pay the interest if not the principle of the debt you have
borrowed. think about a normal boom and bust business cycle. in a bad year your [bridge blows up]
company might shrink to have only two billion of revenues and 180 million
dollars of operating profits. in which case in that dismal year it would have
only one point five times interest coverage. in a great year with say 900
million of operating profit while the coverage ratio would be 6x or 600 [equations]
percent or six times. now put your butt in the seat of the lender. if you're the
one who loaned the two billion dollars at 6% while you're getting pretty
nervous about being able to collect your money back when operating profits are
down to just one point five times. but it's six times interest well you sleep [woman snores in bed]
like a baby happy to keep collecting your interest payment though. so why do
we use operating profits this line here instead of net income or after-tax
profits this line here when we calculate the times interest ratio? well because
interest costs are tax-deductible? they're a cost just like [definitions]
plastic or office building rent or mandatory company yoga retreats. the cost
of renting money is treated for tax purposes really no different from the
cost of renting a building. so we don't worry about taxes when we're focused on
just repaying our debts. just don't try to use that excuse when tax time comes [woman smiles behind desk]
around though. Uncle Sam well he don't play.