In this article we will discuss about interest cover and income gearing in a company.
Interest Cover:
This ratio is calculated to analyse the company’s ability to meet interest obligations. It is expressed as number of times interest earned. It is measured as a ratio of profit before interest and tax to interest charges.
The more the number of times interest earned, safer the position of debt providers.
Income Gearing:
The inverse of interest cover is called ‘income gearing’, indicating the proportion of pre-tax earnings committed to prior interest charges.
The lower the percentage indicates the company’s ability to meet interest obligation in time.
Problem 1:
Quick Fix Ltd’s balance sheet shows the following structure of finance for the year ended 31st March, 2016.
The profit earned during the year before interest payments and tax (@ 40%) amounted to Rs.34 lakhs Board of Directors recommend a dividend @ 18% on equity shares.
You are required to calculate:
(a) Capital gearing ratio,
(b) Income gearing ratio.
Solution:
The gearing ratio is small and the company’s financial risk is lesser.
This shows sufficient cushion for payment of interest to the debenture holders.
Problem 2:
Amitab Ltd’s capital structure on 31-3-2016 includes 5,00,000 equity shares of Rs.10 each, 10,000 debentures of Rs.150 each carrying 15% rate of interest and term loan of Rs.20,00,000 repayable in 7 year period with 18% rate of interest.
Bachan Ltd’s balance sheet shows the following capital structure:
2,00,000 Equity shares of Rs.10 each
32,000 Preference shares of Rs.100 each (12%)
General reserve of Rs.5,00,000
Share premium account Rs.3,00,000
25,000 14% Fully secured Non-convertible debentures of Rs.100 each
From the above data you are required to calculate the leverage of both the firms and compare with each other.
Solution:
Analysis:
It is seen from the above calculations that Amitab Ltd.’s leverage is low as compared to Bachan Ltd.’s leverage and hence its financial risk is less as compared to Bachan Ltd.