Interest Cover Formula

Interest Cover Formula

Interest Cover can be calculated by the following Simple Formula

Interest Cover Formula =  Profit before Interest & Tax.                                               Interest Payable

 Interest Cover Formula Example

Company’s Profit after Interest = 130,000

Interest Payable = 40,000

Calculate interest cover ratio

Solution

Profit before interest = Profit after Interest + Interest

= 130,000 + 40,000

= 170,000

Interest Cover =   Profit before Interest    .   

                              Interest Payable

= 170,000/40,000

= 4.25 (Times)

This example shows that sufficient profit is available to pay interest i.e. 4.25 times than profit.

 Significance of Interest Cover Ratio

Interest cover ratio shows the financial position or capacity of company to pay interest. Interest is an obligatory payment and therefore this ratio provides important information to management for meeting its obligation.

Interest cover ratio provides margin of safety available to the company before it fails or defaults to pay interest on the debt. Interest cover ratio is also very important ratio for the current bond holder or debt financiers and future debt financier. They want to know about company ability or capacity to pay interest on debt Financing.

High Interest Cover Ratio

High interest cover ratio is recommended for companies, however a very high interest ratio indicates that company is not managing its finance properly, because debt is deemed to be cheaper than equity. Thus a very high interest cover ratio indicates that cheap source of financing is not being utilized by the company.

 Low Interest Cover Ratio

Management would love to maintain reasonable or balanced interest cover ratio, because a very low interest cover would shake the confidence of the debt instrument holder. Management would find it difficult to arrange new debt financing in case of low interest cover ratio.

 Ideal Interest Cover Ratio

 Interest cover ratio above 2 is regarded as safe point for the company. This shows that profit are twice that interest liability.

Limitations of Interest Cover Ratio

Interest cover ratio does not based on the cash flow information, which is more effective way or tool to measure the financial position of the company to pay interest. Thus interest cover ratio does not truly reflect the company’s capacity to pay debt.

Current Ratio Formula

Current Ratio Formula

Current ratio tells about the liquidity position of the entity. Current ration can be calculated by dividing current asset with current liabilities of the organization.

Current Ratio =   Current Asset      .                         Current Liabilities

 Current Ratio Formula Example

Closing Stock = 20,000

Closing Debtor= 30,000

Cash = 20,000

Closing Creditor= 10,000

Calculate Current Ration

Solution

Current asset

Closing Stock =  20,000

Closing Debtor= 30,000

Closing Cash =   20,000

                       70,000

Current Ratio =   Current Asset   

                         Current Liabilities

=70,000/10,000

=7:1

Above example shows that current asset are seven times than current liability. Company has more than sufficient liquidity (cash) for liability settlement.

Reasons for High Current Ratio

One of the primary reasons for high current ratio is stock pile up or over manufacturing. Increase in receivable due to relax credit policy may also be a major reason for high current ratio. Early payment to creditors is also major reason for high current ratio.

Reasons for Low Current Ratio

One of the main reasons for low current ratio is high turnover of the stock or low stock maintaining policy. Other reason is delayed payment to the creditors. Decline in sales would also reduce the cash and receivable, and thus a key reason for low current ratio.

Ideal Current Ratio

Current ratio must be at least 1:1. Different industry requires different current ratio. Generally, it is assumed that current ratio between 1.5- 3 is fair. It is important to remember that neither too low nor too high ration (current ratio) is recommended.

Disadvantages of High Current Ratio

One of the main disadvantages of high current ratio is unnecessary poor financial management (funds are unnecessary tied up). High current ratio indicates that more funds are resources are allocated than requirement.

Disadvantages of Low Current Ratio

Companies are required to maintain minimum current ratio; otherwise, companies would not be able to finance the operations. Funds must be available with companies to settle the immediate liabilities.

Default or delayed payment to creditor may negatively impact the goodwill of the company. Similarly default or delayed payment to the financial institution may result in fines and other legal complications for the companies.

Quick Ratio Formula

Quick Ratio Formula

Quick Ratio =   Current Asset -Stock   .                             Current Liabilities

 Quick Ratio Formula Example

Stock in Hand = 30,000

Closing Debtor= 20,000

Cash = 20,000

Closing Creditor= 40,000

Calculate Current Ratio of the company

Solution

Current asset

Stock = 30,000

Debtor= 20,000

Cash =   20,000

            70,000

Quick Ratio =   Current Asset-Stock   

                        Current Liabilities

=(70,000-30,000)/40,000

=40,000/30000

=1:1

Significance of Quick Ratio

Quick ratio tells about the liquidity situation of the company. This ratio is more representative of liquidity position than current ratio, because only liquid asset are included. (Stock is excluded)

Reasons for Exclusion Stock

Stock is regarded as less liquid asset, selling of stock is not certain and  may require or take more time for conversion into liquid asset (cash). Therefore stock is excluded from the current asset for the purpose of calculating the quick ratio.

Other Name of Quick Ratio

Other name of quick ratio is acid test ratio. The term quick ratio and acid test ratio can be used interchangeably.

Ideal Quick Ratio

Quick ratio should be at equal to 1 or more. It means that quick financing should be available to pay immediate liabilities. Quick ratio will vary industry to industry, for some industries quick ratio ranging from 1 to 1.5 ratio may be considered sufficient. For other industries such ratio may be in range of 2 to 3. we can safely say that ideal quick ratio should lie between 1 to 2.

Reasons for High Quick Ratio

High or growing quick ratio indicates those receivables are being chased more aggressively. High quick ratio also indicates growth in the sales. Other reason for high quick ratio may be delayed payment to creditors.

Quick ratio is expected to rise due to early receipt from the debtor, similarly sales growth would also improve the liquidity (cash). late or delayed payment would improve the quick ratio or liquidity of the company.

Reasons for Low Quick Ratio

Reasons for low quick ratio include low performance of collection department. The other obvious reason may be decline is sales or sales growth. One of the main reasons for low or declining quick ratio is early payment to creditors.