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ACCA Applied Knowledge · Financial Accounting · Stakeholders' needs

Zeta Co has revenue of $800,000, profit from operations of $120,000 and finance costs of $30,000. Lenders use interest cover to assess risk. Which statement is correct?

Interest cover is 4 times, calculated as profit from operations of $120,000 divided by finance costs of $30,000. This shows operating profit covers the interest burden four times, which is the measure lenders use to assess risk of non-payment of interest.

  1. AInterest cover is 4 times, which indicates profit is four times the interest burdenCorrect
  2. BInterest cover is 26.7 times because revenue is divided by interest
  3. CInterest cover is 3 times because finance costs are deducted first
  4. DInterest cover is 0.25 times because interest is divided by operating profit

Explanation

Interest cover = profit from operations / finance costs = 120,000 / 30,000 = 4 times. Dividing revenue by interest gives 26.7, using the wrong numerator. Deducting interest first gives 90,000/30,000 = 3, which is wrong because operating profit is before finance costs. The inverse gives 0.25.

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