See: Over-leveraged.
Think: gymnasts doing splits. Overextension happens on a lot of fronts. And more than just stretching groinal areas.
Companies commit to producing 14 million units when they really only have capability of producing 8 million. They're overextended with their buyers who likely themselves have committed to others to deliver 14 million units.
Overextension happens in credit as well. Companies think that they'll keep growing forever. They borrow $100 million at 7% only to find that their business has turned for the worse and they can't pay the piper. They lose the company to a bankruptcy system and, well, they cry. Try doing that while you're doing one of those hurdler stretches and you'll catch the vibe.
Related or Semi-related Video
Finance: What is the Times Covered Inter...23 Views
finance a la shmoop- what is the times covered interest ratio?
okay people. we'll just restate the question if it's simpler. from your [girl frowns in classroom]
operating profits this part of your income statement right here- how many
times is your interest expense covered? still not simple enough? okay how about
this? how big a multiple is your operating
profit of your interest cost? there we set it boom. okay so you run furry nation [definitions listed]
America's finest purveyor of animal bodysuits. the company has two billion
dollars in debt on which you pay six percent interest or 120 million dollars
a year. you really wanted that platinum encrusted fidgets spinner and well you
just couldn't wait. furry nation has revenues of three billion dollars and [hand spins fidget spinner]
conveniently has operating profits of 360 million. so how many times larger is
your operating profit than your yearly interest? well check out the hundred
twenty million dollars error of interest from before, that number gets divided
into the operating profit number. and the answer? three. well why does this ratio [equations]
matter? well the three times interest covered number is a solid indication of
how easily you can pay the interest if not the principle of the debt you have
borrowed. think about a normal boom and bust business cycle. in a bad year your [bridge blows up]
company might shrink to have only two billion of revenues and 180 million
dollars of operating profits. in which case in that dismal year it would have
only one point five times interest coverage. in a great year with say 900
million of operating profit while the coverage ratio would be 6x or 600 [equations]
percent or six times. now put your butt in the seat of the lender. if you're the
one who loaned the two billion dollars at 6% while you're getting pretty
nervous about being able to collect your money back when operating profits are
down to just one point five times. but it's six times interest well you sleep [woman snores in bed]
like a baby happy to keep collecting your interest payment though. so why do
we use operating profits this line here instead of net income or after-tax
profits this line here when we calculate the times interest ratio? well because
interest costs are tax-deductible? they're a cost just like [definitions]
plastic or office building rent or mandatory company yoga retreats. the cost
of renting money is treated for tax purposes really no different from the
cost of renting a building. so we don't worry about taxes when we're focused on
just repaying our debts. just don't try to use that excuse when tax time comes [woman smiles behind desk]
around though. Uncle Sam well he don't play.
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