Acquisition Debt

finance a la shmoop- what is the times covered interest ratio?

okay people. we'll just restate the question if it's simpler. from your [girl frowns in classroom]

operating profits this part of your income statement right here- how many

times is your interest expense covered? still not simple enough? okay how about

this? how big a multiple is your operating

profit of your interest cost? there we set it boom. okay so you run furry nation [definitions listed]

America's finest purveyor of animal bodysuits. the company has two billion

dollars in debt on which you pay six percent interest or 120 million dollars

a year. you really wanted that platinum encrusted fidgets spinner and well you

just couldn't wait. furry nation has revenues of three billion dollars and [hand spins fidget spinner]

conveniently has operating profits of 360 million. so how many times larger is

your operating profit than your yearly interest? well check out the hundred

twenty million dollars error of interest from before, that number gets divided

into the operating profit number. and the answer? three. well why does this ratio [equations]

matter? well the three times interest covered number is a solid indication of

how easily you can pay the interest if not the principle of the debt you have

borrowed. think about a normal boom and bust business cycle. in a bad year your [bridge blows up]

company might shrink to have only two billion of revenues and 180 million

dollars of operating profits. in which case in that dismal year it would have

only one point five times interest coverage. in a great year with say 900

million of operating profit while the coverage ratio would be 6x or 600 [equations]

percent or six times. now put your butt in the seat of the lender. if you're the

one who loaned the two billion dollars at 6% while you're getting pretty

nervous about being able to collect your money back when operating profits are

down to just one point five times. but it's six times interest well you sleep [woman snores in bed]

like a baby happy to keep collecting your interest payment though. so why do

we use operating profits this line here instead of net income or after-tax

profits this line here when we calculate the times interest ratio? well because

interest costs are tax-deductible? they're a cost just like [definitions]

plastic or office building rent or mandatory company yoga retreats. the cost

of renting money is treated for tax purposes really no different from the

cost of renting a building. so we don't worry about taxes when we're focused on

just repaying our debts. just don't try to use that excuse when tax time comes [woman smiles behind desk]

around though. Uncle Sam well he don't play.