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Demystifying Accounts

How well can your business meet its debt??

A set of financial accounts can provide far more than a simple report on the profit  or loss your business has made. Digging a little deeper and running some relatively simple equations can provide a fantastic insight into the strength and health of your business.   There are many tools and measures to assist you in ‘Demystifying your accounts’ to convert the information contained in those financial statements into some useful insights into your business.

In this article we will focus on a measure of the ability of your business to meet its debt servicing requirements.  A ratio your bank manager will want to know, giving them comfort or concern as to your ability to service your debt.

Interest cover ratio

This measure is called the “Interest Cover Ratio” and in simple terms will demonstrate how many times the current interest payments can be paid with the available earnings.  The analysis of this ratio will demonstrate the margin of safety the business has to service debt in the face of changes to the business or the financing cost, i.e. rising interest rates.

The interest cover ratio formula is;

                   earnings before interest and tax (EBIT) ÷ interest expense

The result of the formula will give a number that is the number of times that the earnings of the business can pay the interest costs of the business.  An example of this is as follows;

Example

Company A has a bank loan of $1,000,000 and is being charged interest at an annual rate of 5% giving an interest cost of $50,000 (note for simplicity we have assumed that the loan balance will be unchanged throughout the financial year). 

If this company had earnings before interest and tax of $200,000 the interest cover ratio will be four times ($200,000 ÷ $50,000 = 4) which means there is the ability to meet the interest cost of the company 4 times based on the earnings before interest and tax.  This indicates that the company is in a strong position in relation to their debt.

Scenario testing

However if we make some changes to these assumptions we can see the impact that this will have on the ability for this company to service its current debt.

Assuming all of the same facts but instead an interest rate of 9% ($90,000 of annual interest) the interest cover ratio drops to 2.22 times ($200,000 ÷ $90,000 = 2.22).  Under this scenario there appears to be sufficient ability to maintain any debt servicing requirements of the company so long as nothing else in the business changes that would affect profitability.  The bank might however begin to take notice at this point as to any significant changes to the businesses ability to make the interest payments..

Adding in such a change will demonstrate why it is important to monitor this ratio on an on-going basis.  Assuming that due to the rising interest rates there has been a change in consumer behaviour and the profitability of the business now drops.  If EBIT drops to $70,000 for the year, along with an interest rate of 9%, then the interest cover ratio drops to 0.78.  This means that for every dollar of profit, there is only 78 cents that is available to meet the interest costs of the company.  This will clearly be of great concern to the bank as they will need to consider where the remaining $20,000 of interest payments will be funded from.

Tracking over time

By tracking and reviewing this ratio over time it will provide an insight into the on-going ability of the business to meet the servicing requirement of who is often the most important external stakeholder of the business.  Testing the interest ratio cover under a number of different scenarios to stress test your business may provide some clarity as to what is the right level of debt for the business to carry.

Whats good, whats bad

As each business will have differing debt and profit profiles there is no golden number that should be achieved, however it will always be necessary to maintain an interest cover ratio of more than one.  Anything below one will mean that the interest costs are not being met from the earnings of the business and will require either further borrowing i.e. overdraft or funds being introduced by the owners.

For some businesses an interest cover ratio of 1.5 might be ideal, i.e. commercial rentals where the maximising of debt deductions while the capital value of the building grows. 

Whereas other businesses may require a much higher ratio to ensure that in times of rising interest rates or falling income the ability to continue to service debt will not be compromised. 

An analysis of the DairyNZ Economic Survey indicates that for owner operated dairy operations the average interest cover ratio for the 2013/2014 season was 3.11 whereas for the 2014/2015 the ratio fell to 1.46.  The long run average sits at around 2.3 times as a benchmark measure for the industry. 

For more infomation please contact Rory Noorland on 07 889 8850

 

 

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