SolvedINTM516060 | Thin capitalisation: practical guidance: interest cover - debt servicing: example of an interest cover calculation
From HM Revenue & Customs · International Manual
Consider the following extract from a profit and loss account.
| - | 20XX |
|---|---|
| - | £m |
| Turnover | 161.6 |
| Cost of sales | (115.8) |
| Gross profit | 45.8 |
| Administrative expenses | (20.7) |
| Operating profit | 25.1 |
| Interest receivable | 4.3 |
| Interest payable | (7.6) |
| Profit on ordinary activities before taxation | 21.8 |
| Tax on profit on ordinary activities | (4.6) |
| Profit for the financial year | 17.2 |
Other information is as follows:
Cost of Sales includes the following items:
Depreciation on plant and machinery of £11.4m. Capital expenditure on plant and machinery during the year was £8.4m.
Amortisation of purchased goodwill of £3.5m. This goodwill arose on the acquisition of a competitor’s business.
Amortisation of patent of £0.2m. This intangible asset is being amortised over a ten-year period.
Interest receivable is generated mainly by the placement of surplus operating cash on the overnight money markets.
In the light of the above information, interest cover (as a measure of cash-flow) would be calculated as follows:
| Item | Comment | Amount included in calculation of interest cover (£m) |
|---|---|---|
| Depreciation on plant and machinery | The replacement of plant and machinery is an important feature in the company’s business, as shown by the amount spent in the year on new equipment. A third-party lender may decide to add back the depreciation expense and instead deduct the value of actual capital expenditure. | Add back £11.4m and deduct £8.4m |
| Amortisation of goodwill | Amortisation of goodwill is a non-cash transaction. Purchased goodwill arises where a business is acquired, and the purchase consideration exceeds the fair value of net assets acquired. The acquisition of a business is unlikely to result in future cash payments. | Add back £3.5m |
| Amortisation of intangible asset | This is also a non-cash transaction which - depending on the facts, is unlikely to result in future cash payments. | Add back £0.2m |
| Interest receivable | The interest receivable seems to be a temporary and varying source, so a lender is unlikely to rely on its continued existence. | Interest receivable should not be netted against interest payable, but it may be added to operating profit. |
On the basis of the above comments, the interest cover figure is calculated as follows:
Adjusted operating profit (including interest receivable) = £36.2m (£25.1m+£11.5m-£8.4m +£3.5m+£0.2m+£4.3m)
Interest cover = 4.8 (£36.2m/£7.6m)
If netting of interest receivable with interest payable had been allowed, the interest cover would be 9.7 (£31.9m/£3.3m) - a significant difference.