Page 129 - Finance for Non-Financial Managers

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Finance for Non-Financial Managers
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• interest rates that impact the cost of money, since long-
term debt is typically borrowed under formal lending
agreements that bear interest, as opposed to trade credi-
tors’ balances, which are generally interest-free
• how profitable the company can be in its industry, since a
low-margin business can ill afford to pay high interest
rates for additional capital, while a high-margin, high-
growth business may be able to profit handsomely from
every dollar it can get.
Interest Coverage
This metric is of use pretty much exclusively to bankers that
lend money and to the companies that borrow it. Interest cover-
age attempts to measure how well a company’s cash flow will
succeed in paying the interest on its interest-bearing debt. The
calculation doesn’t use actual cash flow. Instead, it uses EBIT-
DA (discussed in Chapter 4) as a stand-in for cash flow and
actual interest expense to determine how many times the inter-
est expense is covered by approximate cash earnings for the
same period. Here’s a computation of interest coverage:
EBITDA 50,000
= = 9.1 times
Interest Expense 5,500
The value of this metric to lenders is pretty obvious. They
may even have a minimum acceptable ratio or be closely
watching trends here, because this is important to them. They
want to know that they have a safe margin to ensure they will
not have a nonperforming loan on their hands in the event of a
reversal in the fortunes of their borrower, however temporary.
The thinking of the lenders is that, worst case, they can at least
collect interest until the borrower is again able to make full pay-
ments. The borrower probably doesn’t look at this number very
closely, except because its lenders are looking at it and they
might get upset if it gets too low compared with expectations or
if the number falls below 8 or 10 times interest expense. If
you’re the borrower and cash flow is tight, you might want to
watch this one closely, to give you a heads-up before your