Thin capitalisation: practical guidance: interest cover - debt servicing: what interest cover means
Loan agreements include promises or undertakings called covenants (see INTM515010), which are applied to a borrower’s balance sheet or operating results at intervals to check that it is maintaining its ability to service and repay the borrowing. The breaching of a covenant by a borrower will normally trigger close attention from the lender.
Loan covenants commonly include a maximum ratio of debt to earnings and a minimum ratio of earnings to interest costs. The latter ratio is known as ‘interest cover’. Interest cover covenants are common in third party loan agreements and are a mainstay of thin capitalisation agreements.
A borrower’s interest cover is a measure of its ability to service its debt - to pay the interest and other regular costs of borrowing - rather than of its ability to repay the principal.
The basic calculation is as follows:
|Interest cover =||Earnings before interest and tax (EBIT)|
This ratio shows how many times the profits for the period can cover the interest charge for the period. For example, if the profit per the accounts before interest (payable or receivable) and tax is £12m and the interest payable is £3m, then EBIT is £12m and the interest cover is 4:1. This ratio gives an indication of the company’s ability to meet the interest expense.
Interest cover covenants have been adopted for use in Advance Thin Cap Agreements to measure arm’s length interest for each year of the agreement. In the event of a breach of covenant, enough interest is disallowed to restore the ratio. In the above example, say the covenant was 4:1 and the interest payable was £3.25m. Disallowance of £0.25m, would “restore” the covenant. These covenants therefore establish parameters within which interest deductions are accepted as arm’s length and outside of which they are non-arm’s length.