The ability of the
company to pay interest expenses is an important aspect from the creditor or
financier’s point of view. Debt service ratio facilitates measuring the
serviceability of interest expenses by an entity.
Interest Coverage
This ratio presents
the relationship between income before interest and taxes (or Earnings before
interest and taxes, EBIT) and total interest obligations. Annual earnings are
the basic source for providing debt services and must be sufficient enough to
pay off debt and interest. Changes in this ratio might signal problems for debt
servicing. The ratio is calculated using the following formula:
=
Earnings before Interest & Tax/Zakat
Interest Expenses
The outcome of the
ratio is expressed in number of times the interest earned by the company.
A higher ratio
indicates the ability of a company to make interest payments from current
earnings.
Fixed Financial Cost Ratio
It is necessary to
consider the impact of the lease obligations on the coverage ratio. A slight
variation on the interest coverage ratio is to recognize that firms that use
leased facilities are in essence borrowing the capital to utilize those
facilities. Higher coverage ratios suggest the firm is better able to manage its
current debt levels or that the firm has unused borrowing capacity. These lease
payments are accounted for in the fixed financial cost ratio:
=
Earnings before Interest & Tax/Zakat + ELIE
Interest Expenses + ELIE
where: ELIE = estimated lease interest
expense
Cash Flow Coverage of Fixed Financial
Costs
A different type of
variation in the coverage ratio is to use cash flow instead of income in the
numerator. The basis of the cash flow measure is cash flow from operations (CFO)
found in the financial statements. In this form, the cash flow measures include
depreciation expense, deferred taxes, and the impact of changes in net working
capital. This version of the ratio is defined as:
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