Hi guys, please help me with this question. Im not really understand why they add capitalized interest (Notes to financial statement) to interest expense. Thank you.
Question:
A company’s debt covenant requires it to maintain an interest coverage of 2.25; the ratio is calculated using total interest paid. The following information is taken from the company’s 2014 financial statements:
| 2014 | $ thousands |
|---|---|
| Net sales | 11,159 |
| Cost of goods sold (COGS) | 9,898 |
| Selling and administrative expense (S&A) | 872 |
| Interest expense | 122 |
| Earnings before tax | 267 |
Note 11: Property and Equipment (all figures in $ thousands)
Depreciation expense for 2014 is $388. This amount includes capitalized interest of $34.
Interest is allocated and capitalized to construction in progress by applying the firm’s cost of borrowing rate to qualifying assets. Interest capitalized in 2014 is $66.
Note 13: Long-Term Debt
All bonds were issued at par.
The most appropriate statement about the company’s debt covenant restriction in 2014 is that the firm:
- just satisfied it.
- failed to meet it by at least 5%.
- exceeded it by at least 5%.
Solution
A is correct.
| ($ thousands) | |
|---|---|
| EBIT = Sales – COGS – S&A = 11,159 – 9,898 – 872 = | 389 |
| Add back depreciation related to capitalized interest | 34 |
| Adjusted EBIT | 423 |
| Interest expense: Income statement | 122 |
| Add capitalized interest: Notes to financial statement | 66 |
| Total interest paid | 188 |
The interest coverage ratio requirement has been exactly achieved.
Because the bonds were issued at par, no amortization of premiums or discounts is included in interest paid.