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Interest Coverage Ratio

QuestionsCategory: Financials QuadrantInterest Coverage Ratio
Michael Lim asked 5 years ago

I Encounter 2 different type of calculation for interest coverage ratio.

  1.  Operating Cash Flow / interest Expense
  2. Earning before Interest & Tax / interest Expense

Using back OUE FY 2015 Report as an example. 

  • Operating Cash Flow = 55,265 (Page 56 of PDF file)
  • EBIT= 257,809 (Page 54 of PDF file)
  • Interest Expense= 89,135 (Page 54 of PDF file)

We will get 2 very different result.
Would you advise, which formula is better to use?
Would it company specific to decide the formula? i.e Property companies use EBIT/Interest Expense while OCF/interest expense can be applied other companies.
Thanks!

3 Answers
Rusmin Ang Staff answered 5 years ago

Hi Michael,
 
Thanks for the well-crafted question (the link attachment is very useful).
 
For property development companies, I would usually use gearing (borrowing/total assets) to assess the credit profile of the company. The gearing works out to be 35.9% (moderately high and once above 40%, i would consider it very high). Interest cover is better indicator if the company (i.e. REIT) has predictable cash flow and earnings. In the case of OUE, their earnings and cash flow tend to be lumpy due to the nature of property construction business. 
 
On the side note, OUE’s cash flow doesn’t take into account of dividends paid by its equity accounted investees (I assume this is from OUE hospitality). So if you were to use cash flow, remember to take this into consideration. Even then, OUE FY2015 cash flow is extremely weak. 

Michael Lim replied 5 years ago

Hi Rusmin,

My gearing ratio is about the same as yours. Glad that i have applied correctly.

Total Borrowing = 292,4547 (157,195 + 2,767,352)
Total Assets = 8,129,838
Gearing Ratio = 35.97 %

I have read that in Peter Lynch Book, he would prefer minus off the total borrowing with cash and cash equivalents before using it in calculation. I guess we are more conservative here in our calculation right? :)

Rusmin Ang Staff replied 5 years ago

Yes, we are more conservative. Peter lynch’s method works fine for normal gearing ratio (gearing/equity) :)

Michael Lim answered 5 years ago

Hi Rusmin,
Thank you for answering the question. 
OUE comes to my attention as it has one of the biggest discount to its NAV among the property developers. I was thinking if it could be a potential asset play in the future. Hence, I was reading the annual reports to give me insight into the company.
I do notice the earning of OUE is lumpy, time to time it develops properties and inject them into its REITS. I am paying attention if the REITS (OUE HTrust and OUE Commerical) that it manage can provide more recurring income in the future.
I am a subscribers to both Dividend Machine and Investment Quadrants. I find the contents in IQ much more in depth and has a higher level of difficulty compared to DM. While i manage to cover and digest the contents in DM in less than a month, i have to spend considerable more time to digest IQ.
When i apply the contents in IQ on actual annual reports, several more questions comes out as each companies are unique. Having this Q&A platform is extremely helpful and important. 
Once again, thanks for answering

Rusmin Ang Staff answered 5 years ago

Hi Michael,
 
Glad you’re learning more. IQ actually needs a lot of work but if you’re lazy, you can explore Alpha Lab where you can just leverage on our work. You’re always welcome to ask question whenever you’ve them. We will be here to answer them!