INTM515020 - Thin capitalisation: practical guidance: measuring earnings: earnings before interest and tax (EBIT)

The EBIT formula is based on the figure for operating profit, and it is used in thin cap to help measure the ability of a company to service its debts. The following example demonstrates how it is calculated:

-	2012	2013
-	£m	£m
Turnover	61.6	49.5
Cost of sales	(15.8)	(13.6)
Gross profit	45.8	35.9
Administrative expenses	(20.8)	(17.5)
Operating profit	25.0	18.4
Interest receivable	1.3	1.2
Interest payable	(7.6)	(7.5)
Profit on ordinary activities before taxation	18.7	12.1
Tax on profit on ordinary activities	(3.9)	(2.7)
Profit on ordinary activities after taxation	14.8	9.4

This is used to work out “interest cover” - how many times the profit “covers” the interest expense. This is one of the ways of measuring a company’s ability to borrow (see INTM516000)

Calculation of Interest Cover (EBIT/Interest payable)

2012

• Interest cover = 25.0/7.6 = 3.29:1

2013

• Interest cover = 18.4/7.5 = 2.45:1

In this example, both interest payable and interest receivable are excluded from the calculation of EBIT. However, given that interest receivable represents a source of cash, it may be legitimate to add it to earnings in calculating income. The case for doing so is more persuasive if the source of the interest receivable is likely to be regular and stable, such that a lender would feel able to place some long-term reliance on it.

See INTM516040 for more information on when it is appropriate to net off interest receivable against interest payable. It may also be worth looking at the borrower’s use of spare cash. The borrower may lend on to other group members (often non-UK) at a lower return than the borrower pays on its own debt. It is often arguable that at arm’s length, some of this cash would have been used to reduce debt and a commercial reward would be sought for cash retained. A transfer pricing adjustment may be appropriate in these circumstances.