R24 Integration of Financial Statement Analysis Techniques

[IFT Team]

[Brett Stehl]

Interest Coverage Ratio - this is very frustrating and confusing.... On the financial ratio list in the CFA curriculum they list the Interest Coverage Ratio as EBIT/Interest Payments, however in the examples they use it as EBIT/Int Expense.

On question #8 of Reading 18 they say the interest coverage ratio does not change because although the interest expense increased by capitilizing, the ratio did not change because you are already included the expensing in the interest payments.  This is very confusing and contradictory to what the examples and text say (including your materials that say the coverage ratio is higher initially by capitilizing). Not only that but isn't EBIT higher with Capitilizing?

To go further.  On Reading 24 - Question #4 they are saying the original interest coverage ratio is 865/35 - by stating this they are assuming the 35 is just interest expense not interest payments (also contradictory.)

My questions for you and the CFA exam makers is:

On the exam for Capitalizing versus Expensing should we just answer that the interest coverage ratio is unchanged?  

Even if the interest payments are the same isn’t EBIT higher in the early years by capitalizing?

 

I am also wondering how to answer the interest coverage ratio question for financing versus operating – the EBIT is higher under financing correct?

[Arif Irfanullah]

Brett,

You have a very good point.

Unfortunately there is no standardization with ratios.  This is also apparent in the curriculum where the same ratio (such as the interest coverage ratio) will have slightly different formulas from reading to reading.

When you are evaluating a ratio you need to understand the exact formula used by the author.  This should be given either explicitly or implicitly in the text.

Once you know what formula is being used you can decide on the appropriate adjustment.

Regards,

Arif Irfanullah

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Arif Irfanullah

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Irfanullah Financial Training

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