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HMRC internal manual

International Manual

Thin capitalisation: practical guidance: interest cover - debt servicing: example of an interest cover calculation

Consider the following extract from a profit and loss account.

    20XX
     
    £m
Turnover   161.6
Cost of sales   (115.8)
Gross profit   45.8
Administrative expenses   (20.7)
Operating profit   25.1
Interest receivable   4.3
Interest payable   (7.6)
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:

  1. 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.
  1. 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.