Analyst Ottoline Marchbank is reviewing Fenwick Rail Supply on behalf of its bondholders. The company reports earnings before interest and taxes (EBIT) of $42,000,000 and annual interest expense of $14,000,000. A covenant in the indenture requires that EBIT cover interest by at least 2.5 times. Which statement is correct?
- A.Coverage is 3.0 times, so Fenwick is in compliance, and EBIT could fall by $7,000,000 before the covenant would be breached.Correct. $42,000,000 / $14,000,000 = 3.0 times, above the 2.5 times floor. The minimum permitted EBIT is 2.5 x $14,000,000 = $35,000,000, a cushion of $7,000,000.
- B.Coverage is 0.33 times, so Fenwick is in breach of the covenant.Incorrect. This inverts the ratio. Interest divided by EBIT is not a coverage measure; coverage asks how many times earnings cover the interest bill.
- C.Coverage is 3.0 times, but the ratio measures the company's ability to repay principal at maturity rather than to pay interest.Incorrect on the second half. Times interest earned measures the cushion for servicing INTEREST. Repaying principal at maturity is a separate refinancing and liquidity question.
- D.Coverage is 2.0 times, because interest expense must be compared with earnings after tax.Incorrect. Interest is deductible and is paid out of pre-tax operating earnings, which is why the numerator is EBIT rather than net income.
Why: Times interest earned, also called the interest coverage ratio, is EBIT divided by annual interest expense: $42,000,000 / $14,000,000 = 3.0 times. That is above the 2.5 times covenant, so Fenwick is in compliance. To find the cushion, solve for the EBIT level that produces exactly 2.5 times coverage: 2.5 x $14,000,000 = $35,000,000. EBIT could therefore fall by $7,000,000 (from $42 million to $35 million, a decline of about 16.7%) before the covenant is breached.