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# Debt Service Ratio or Interest Coverage Ratio:

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## Definition:

The ratio measures debts servicing capacity of a business so far as interest on long-term loans is concerned. This ratio shows how many times the interest charges are covered by the earnings. Debt service ratios is also know as interest coverage ratio.

## Formula:

The ratio is calculated with following formula:

Debt service ratio = Earnings before interest and taxes (EBIT) / Fixed interest charges

## Example:

From the following, calculate interest coverage ratio.

 \$ 9% Mortgage loan 10,00,000 7.5% Debentures 12,00,000 Net profit (after tax) 9,72,000 Income tax rate 50 %

Solution:

Interest coverage ratio = Earnings before interest and tax / Fixed interest charges

= 21,24,000* / 1,80,000**

11.8 times

Working:

(i) Calculation of Interest Payable:

(l0,00,000 × 9 / 100 ) + (12,00,00 × 15 / 2 × 1 / 100)

90,000 + 90,000

= \$1,80,000**

(ii) Calculation of Tax Liability:

Tax rate = 50%

Profit after tax = 972,000

Tax amount = [9,72,000 / (100 - 50)] x 50

= 9,72,000

(iii) Profit before Interests and Tax:

= Profit after tax + Tax + Interest

= 9,72,000 + 9,72,000 + 1,80,000

= 21,24,000*

Net profits available for payment of interest are approximately 12 times. It implies that even if earnings decline to 1/11th of the current figure long-term creditors interest repayments is safe.

More study material from this to

## More study material from this topic:

 Meanings, Nature and Usefulness of Ratios Analysis Interpretation of Ratios Important Factors for Understanding Ratios Analysis Significance and Usefulness Ratios Analysis Classification of Ratios Analysis of Short Term Financial Position or Test of Liquidity Current Ratio Quick/Acid Test/Liquid Ratio Absolute Liquid Ratio Inventory/Stock Turnover Ratio Debtors / Receivable Turnover Ratio Creditors / Payables Turnover Ratio Working Capital Turnover Ratio Profitability Ratios Gross Profit Ratio (GP Ratio) Operating Profit Ratio Net profit ratio (NP ratio) Earnings Per Share Ratio Operating ratio Expense ratio Solvency ratios - Test of Long Term Solvency Debt-equity Ratio Debt Service Ratio or Interest Coverage Ratio Fixed Assets Ratio Debts to Total Funds or Solvency Ratio Reserves to Capital Ratio Capital Gearing Ratio Proprietary Ratio Accounting Ratios Formulas Limitations of Ratios Analysis

A D V E R T I S E M E N T

 Financial Accounting Topics Introduction to Accounting ---------------------------------------------------------------------------- Transactions and Accounting Equation ---------------------------------------------------------------------------- Analysis of Business Transactions ---------------------------------------------------------------------------- Journal, Ledger and Trial Balance ---------------------------------------------------------------------------- Accounting for Bills of Exchange ---------------------------------------------------------------------------- Special Journals ---------------------------------------------------------------------------- Cash Book ---------------------------------------------------------------------------- Bank Reconciliation Statement ---------------------------------------------------------------------------- Final Accounts ---------------------------------------------------------------------------- Work Sheet ---------------------------------------------------------------------------- Capital and Revenue Items ---------------------------------------------------------------------------- Valuation of Inventories ---------------------------------------------------------------------------- Accounts of Non-profit Making Organizations ---------------------------------------------------------------------------- Statement of Cash Flows ---------------------------------------------------------------------------- Accounting Ratios Analysis ---------------------------------------------------------------------------- Depreciation, Provisions and Reserves ---------------------------------------------------------------------------- Accounting Dictionary ---------------------------------------------------------------------------- Financial Calculators

 Managerial Accounting Topics Financial Statements ---------------------------------------------------------------------------- Cost Volume Profit Relationship ---------------------------------------------------------------------------- Variable Costing System ---------------------------------------------------------------------------- Materials and Inventory Cost Control ---------------------------------------------------------------------------- Activity Based Costing System ---------------------------------------------------------------------------- Standard Costing and Variance Analysis ---------------------------------------------------------------------------- Balanced Scorecard ---------------------------------------------------------------------------- Capital Investment Analysis/Capital Budgeting