Thin capitalisation: practical guidance: interest cover - debt servicing: example of an interest cover calculation
Consider the following extract from a profit and loss account.
|Cost of sales||(115.8)|
|Profit on ordinary activities before taxation||21.8|
|Tax on profit on ordinary activities||(4.6)|
|Profit for the financial year||17.2|
Other information is as follows:
- Cost of Sales includes the following items:
* Depreciation on plant and machinery of £11.4m. Capital expenditure on plant and machinery during the year was £8.4m. * Amortisation of purchased goodwill of £3.5m. This goodwill arose on the acquisition of a competitor’s business. * Amortisation of patent of £0.2m. This intangible asset is being amortised over a ten-year period.
- Interest receivable is generated mainly by the placement of surplus operating cash on the overnight money markets.
In the light of the above information, interest cover (as a measure of cash-flow) would be calculated as follows:
|Item||Comment||Amount included in calculation of interest cover (£m)|
|Depreciation on plant and machinery||The replacement of plant and machinery is an important feature in the company’s business, as shown by the amount spent in the year on new equipment. A third-party lender may decide to add back the depreciation expense and instead deduct the value of actual capital expenditure.||Add back £11.4m and deduct £8.4m|
|Amortisation of goodwill||Amortisation of goodwill is a non-cash transaction.|
|Purchased goodwill arises where a business is acquired, and the purchase consideration exceeds the fair value of net assets acquired. The acquisition of a business is unlikely to result in future cash payments.||Add back £3.5m|
|Amortisation of intangible asset||This is also a non-cash transaction which - depending on the facts, is unlikely to result in future cash payments.||Add back £0.2m|
|Interest receivable||The interest receivable seems to be a temporary and varying source, so a lender is unlikely to rely on its continued existence.||Interest receivable should not be netted against interest payable, but it may be added to operating profit.|
On the basis of the above comments, the interest cover figure is calculated as follows:
Adjusted operating profit (including interest receivable) = £36.2m (£25.1m+£11.5m-£8.4m +£3.5m+£0.2m+£4.3m)
Interest cover = 4.8 (£36.2m/£7.6m)
If netting of interest receivable with interest payable had been allowed, the interest cover would be 9.7 (£31.9m/£3.3m) - a significant difference.