In this article we will discuss about interest cover and income gearing in a company.
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.
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.
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.
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.
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.
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.