Question

From the following calculate Interest coverage ratio Net profit after tax Rs 12,00,000; 10% debentures Rs 1,00,00,000; Tax Rate 40%

a) 1.2 times
b) 3 times
c) 2 times
d) 5 times

Answer 1

The Interest Coverage Ratio is calculated using the formula ICR = EBIT / Interest Expense. After finding the EBIT by adding back taxes and interest expense to Net Profit After Tax, the Interest Coverage Ratio is determined to be 3 times.

Step-by-step explanation:

To calculate the Interest Coverage Ratio (ICR), we need to determine how many times a company can cover its interest obligations with its earnings before interest and taxes (EBIT). The formula for ICR is:

Interest Coverage Ratio = EBIT / Interest Expense

However, we only have the Net Profit After Tax, which can be used to calculate EBIT by adding back the taxes and interest expense. In this case, the interest expense is the payment on the 10% debentures. Here's how the calculation is done:

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Since Net Profit After Tax is after a 40% tax, to find the profit before tax, we divide by (1 - Tax Rate), thus:

Profit Before Tax = Net Profit After Tax / (1 - Tax Rate)
= Rs 12,00,000 / (1 - 0.40)
= Rs 12,00,000 / 0.60
= Rs 20,00,000

Now let's find EBIT by adding the Profit Before Tax and Interest Expense:

EBIT = Profit Before Tax + Interest Expense
= Rs 20,00,000 + Rs 10,00,000
= Rs 30,00,000

Finally, we can calculate the ICR:

Interest Coverage Ratio = EBIT / Interest Expense
= Rs 30,00,000 / Rs 10,00,000
= 3 times

Therefore, the Interest Coverage Ratio is 3 times, which corresponds to option (b).