Section: 2 Financial Ratio Analysis

Sub Section: 2 Debt Service Ratio

The ability of the company to pay interest expenses is an important aspect from the creditor or financier’s point of view. Debt service ratio facilitates measuring the serviceability of interest expenses by an entity.


Interest Coverage

This ratio presents the relationship between income before interest and taxes  (or Earnings before interest and taxes, EBIT) and total interest obligations. Annual earnings are the basic source for providing debt services and must be sufficient enough to pay off debt and interest.  Changes in this ratio might signal problems for debt servicing.  The ratio is calculated using the following formula:



Earnings before Interest & Tax/Zakat

Interest Expenses


The outcome of the ratio is expressed in number of times the interest earned by the company.


A higher ratio indicates the ability of a company to make interest payments from current earnings. 


Fixed Financial Cost Ratio

It is necessary to consider the impact of the lease obligations on the coverage ratio. A slight variation on the interest coverage ratio is to recognize that firms that use leased facilities are in essence borrowing the capital to utilize those facilities. Higher coverage ratios suggest the firm is better able to manage its current debt levels or that the firm has unused borrowing capacity. These lease payments are accounted for in the fixed financial cost ratio: 



           Earnings before Interest & Tax/Zakat + ELIE                

Interest Expenses + ELIE


where: ELIE = estimated lease interest expense


Cash Flow Coverage of Fixed Financial Costs

A different type of variation in the coverage ratio is to use cash flow instead of income in the numerator. The basis of the cash flow measure is cash flow from operations (CFO) found in the financial statements. In this form, the cash flow measures include depreciation expense, deferred taxes, and the impact of changes in net working capital. This version of the ratio is defined as:



Net CFO + Interest Expense + ELIE

Interest Expenses + ELIE