Question

Suppose a business is capitalized with $500,000 in Owners’ Equity plus $400,000 in loans which carry a 5% interest rate. This year’s projected revenue is $1 million, with variable and fixed costs $600,000 and $100,000 (no depreciation), respectively. Profits taxes are 25%.

                  Calculate the coverage ratio for the year. Do it two ways: By moving down the waterfall, to see the money available to service debt. And by moving up from the bottom of the waterfall – that is, adding back taxes and interest to profits.

Answer 1

Moving Down
Revenue	1000000
(-) Variable cost	600000
Contribution	400000
(-) Fixed cost	100000
EBIT	300000
(-) Interest	20000
EBT	280000
(-) Tax	70000
EAT	210000

Debit coverage Ratio = EBIT / Interest

= 300,000 / 20,000

= 15 times

Moving Up
EAT ( Earnings after tax )	210000
(+) Tax = 210000*25/75	70000
EBT	280000
(+) Interest	20000
EBIT	300000

Debt coverage ratio = EBIT / Interest = 300,000 / 20000 = 15 times.