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Using the Interest Coverage Ratio

account calculate In one of our previous article, we looked at what could happen if we invest in a company that goes bankrupt. As an investor, how can we protect ourselves from reaching that stage? One way would be to assess the health of a company that we are about to invest in using the interest coverage ratio. This can be a quick method to check if a company has enough earnings to service its debt.

Interest Coverage Ratio

The Interest coverage ratio is one of the most commonly used ratios that allow investors to check if a company has enough earnings to cover its interests cost. Interest coverage ratio can be calculated by using “Earnings before interests and taxes” divided by the annual interest expense. For example, a ratio of 3 means that the company has earnings that can cover 3 times their interests cost. Generally, a company with a higher ratio is considered to be in a stronger position.

Using two of the largest property developers in South East Asia, CapitaLand Ltd (SGX: C31) and City Developments Ltd (SGX: C09) as examples, let’s take a look at the earnings and debt of these two companies. We know that real estate is a highly capital intensive business. Companies need large amount of money to purchase land and fund development. Many times, much of this cash is financed by the banks. As a result, understanding the interest coverage ratio of a property developer is essential if you are thinking of investing in the company.

S$’000

Net Income

Interest

Taxes

EBIT

Interest Coverage

Capitaland

S$1,316,571

S$498,953

S$201,907

S$2,017,431

4.04

CDL

S$860,338

S$78,867

S$99,901

S$1,039,106

13.18

Source: 2012 Annual Report of CapitaLand Ltd and City Development Ltd

From the 2012 data, it can be seen that the two developers are using different strategy in term of financing for their projects. CapitaLand has enough earnings to cover its interest by 4 times while CDL can cover its 2012 interest costs by 13 times.

CapitaLand uses a higher percentage of debt to finance its business as compared to CDL. A lower coverage ratio does not necessarily indicate that it is a less ideal company to invest in. As long as the company has sufficient earnings to pay its interests, the company can find the optimal debt level for them to operate at the highest efficiency. There are many other factors to consider when investing in a company, but the interest coverage ratio gives the investor a glimpse into the company’s financing strategy.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.

See all posts by Stanley Lim, CFA


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