A company’s financial health can be assessed using a variety of criteria. One example is the times interest earned ratio. Here’s all you need to know, including the formula and how to make the times interest earned ratio calculation.
What is the Times Interest Earned Ratio?
The Times Interest Earned (TIE) ratio assesses a firm’s capacity to meet its debt commitments on a regular basis. Divide a company’s EBIT by its periodic interest expense to determine this ratio. The ratio represents the number of times a corporation could theoretically pay its periodic interest expenses if 100% of its EBIT was dedicated to debt repayment.
The TIE’s primary function is to assist in quantifying a company’s likelihood of default. This, in turn, aids in the determination of key debt criteria such as the right interest rate to be charged or the amount of debt that a company can safely incur.
Understanding the Times Interest Earned Ratio
It’s helpful to look at a times interest earned ratio explanation of what this figure really means to better grasp the TIE. The TIE can be thought of as a solvency ratio because it measures how readily a company can meet its financial obligations. Because interest payments are set, long-term expenses, are employed as the metric. If a company struggles to pay fixed expenses like interest, it risks going bankrupt. As a result, the ratio provides an early warning that a company may need to pay off existing debts before taking on new ones.
The TIE particularly assesses how many times a company’s interest expenses may be covered in a certain period. While it is unnecessary for a corporation to be able to pay its debts more than once, a larger ratio suggests that there is more money available. A higher level of discretionary income indicates that the company is in a better position for growth, as it can invest in new equipment or fund expansions. When the company has money to put back into the business, it’s apparent that it’s doing well.
The Formula for the Times Interest Earned Ratio Calculation
Divide a company’s profits before interest and taxes (EBIT) by its periodic interest expense to get the times interest earned ratio. The formula for the times earned interest ratio calculation is as follows:
Earnings Before Interest and Taxes/Interest Expense = TIE Ratio
Times earned Interest Ratio Formula
Where:
- Earnings Before Interest and Taxes (EBIT) – reflects profit earned by the company before interest or tax payments.
- Interest Expense – the periodic debt payments that a firm is required by law to make to its creditors.
In general, the larger the TIE ratio, the better. A corporation with an overly high TIE ratio, on the other hand, may suggest a lack of productive investment by the company’s management. An abnormally high TIE shows that the corporation is retaining all of its earnings rather than reinvesting in business expansion through R&D or pursuing good NPV ventures. This could lead to a lack of profitability and long-term issues with continuous growth for the company.
Analysis
The times interest ratio is expressed numerically rather than as a percentage. The ratio reveals how many times a corporation might pay interest with its pre-tax income. Hence greater ratios are obviously preferred over lower ratios.
In other words, a ratio of 4 indicates that a corporation generates enough revenue to cover its total interest expense four times over. In other words, this company’s income is four times greater than its annual interest payment.
As you can see, creditors would prefer a corporation with a much larger times interest ratio. This is because it demonstrates the company’s ability to pay its interest payments when they are due. Lower ratios suggest credit risk, whereas higher ratios indicate less risk.
Example
Tim’s Tile Service is a construction company that is looking for a fresh loan to purchase equipment. Before considering Tim’s loan, the bank requests his financial statements. According to Tim’s income statement, he earned $500,000 before interest and taxes. Tim’s total annual interest expense was only $50,000. Tim’s times interest earned ratio calculation is as follows:
TIE Ratio = $500,000/$50,000 = 10 Times
Tim, as you can see, has a ten-to-one ratio. Tim’s revenue is thus ten times more than his annual interest expenditure. In other words, Tim can afford to pay higher interest rates. Tim’s firm is less risky in this regard, and the bank should have no trouble accepting his financing.
What is a Good Times Interest Earned Ratio?
The number 20represents a high times interest earned ratio. There is no perfect solution to the question “what is a good times interest earned ratio?” because it depends on the type of business and industry. It is more crucial to consider what the ratio means for a business, indicating how many times it can pay its interest.
At the same time, if the times interest earned ratio is very high, investors may conclude that the company is extremely risk-averse. Although it is not incurring debt, it is not reinvesting its profits in business development. This situation may also necessitate prudence. In other words, the company is not overextending itself, but it may not be reaching its full potential for growth. The TIE ratio, like any other metric, should be viewed in conjunction with other financial indicators and margins.
What a High Interest Earned/Interest Paid Ratio Can Tell You
A greater times interest earned ratio is desirable since it indicates that the company poses less of a danger of insolvency to investors and creditors. An organization with a times interest earned ratio of more than 2.5 is deemed an acceptable risk by an investor or creditor. Companies with a times interest earned ratio of less than 2.5 are deemed significantly more likely to fail or default.
A times interest earned ratio can be inefficiently large as well. A corporation can choose to pay off debt rather than reinvest extra cash in the company through expansion or new projects. As a result, a company with a high times interest earned ratio may fall out of favor with long-term investors.
The Importance and Applications of the Times Earned Interest Formula
One of the most essential formulas for creditors to use in determining a company’s credit health is the times earned interest formula. The times earned interest ratio formula indicates how many times a corporation’s operating earnings from business activities can cover the total interest expense for the company in a specific period of time. The times interest earned ratio is a type of solvency ratio since the majority of the company’s total interest comes from long-term debt. This ratio assists lenders in determining whether the company will be able to repay its debt and serve its interest in the normal course of business.
According to the example above the company’s times interest earned ratio is 10. It means that the corporation can earn ten times more operating income than the amount of interest it has paid to the lenders. Creditors or investors in a firm look for this ratio to determine whether it is high enough for the company. The higher the ratio, the better it is from the perspective of lenders or investors. A lower ratio indicates both liquidity concerns for the corporation and, in rare situations, solvency issues for the company.
If the company does not generate enough operating income through normal business operations, it will be unable to service the debt’s interest. In that event, it will face a liquidity crisis. Hence, it may be forced to liquidate assets or incur further debt in order to service the interest component of earlier debts. This will eventually have an effect on the business and may result in a solvency issue for the company.
How to Apply Times Earned Interest Ratio?
Analysts should evaluate the ratio’s time series. A single point ratio may not be an ideal metric because it includes one-time sales or earnings. Companies that have stable earnings will have a consistent ratio throughout time, indicating that they are in a better position to service debt.
Smaller enterprises and startups, on the other hand, with inconsistent earnings, will have a changing ratio over time. As a result, lenders prefer not to lend to such businesses. As a result, these firms have more equity and raise funds from private equity and venture capitalists.
Banks and financial lenders frequently examine several financial measures to verify the company’s solvency and ability to service its debt before taking on additional debt. Banks frequently examine the debt ratio, the debt-to-equity ratio, as well as the interest earned/interest paid ratio. The negative ratio implies that the company is in severe financial distress.
Limitations of the Times Earned Interest Ratio
This ratio has a number of faults, which are discussed more below.
#1. EBIT does not equal cash.
The EBIT value in the formula’s numerator is an accounting calculation that does not always correspond to the amount of cash generated. Thus, while the ratio may be excellent, a company may not have enough cash to cover its interest rates. The opposite can also be true, where the ratio is quite low despite the borrower having considerable positive cash flows.
#2. Discounts or premiums may be included in interest.
The amount of interest expenditure in the formula’s denominator is an accounting calculation that may include a discount or premium on the sale of bonds. So, it does not correspond to the real amount of interest expense that must be paid. In these instances, the interest rate mentioned on the face of the bonds is preferable.
#3. It does not include upcoming principal payments.
The ratio does not account for any imminent principal paydown, which may be substantial enough to put the borrower into bankruptcy, or at the very least require it to refinance at a higher rate of interest and with stricter loan conditions than it presently has.
#4. Incorrect Funds Availability Indication
Deducting depreciation and amortization from the EBIT amount in the numerator is a variant of the times interest earned ratio. However, because depreciation and amortization are related to a company’s requirement to buy fixed assets and intangible assets on a long-term basis, they may not represent money available for interest cost payment.
Conclusion
The times interest earned ratio assesses a company’s solvency. While a higher calculation is frequently preferable, high times earned interest ratio may also indicate that a company is inefficient or does not prioritize business growth.
Times Earned Interest Ratio FAQs
What does a times interest earned ratio of 3.5 mean?
EBIT covers the company’s interest obligations 3.5 times over.
What does a low times interest earned ratio Mean?
A ratio of less than one suggests that a company may be unable to meet its interest obligations and is thus more likely to default on its debt; a low ratio is also a significant signal of probable bankruptcy.
Can times interest earned ratio be negative?
If you record a net loss, your times interest earned ratio will also be negative. If your company has a net loss, the times interest earned ratio is usually not the optimum ratio to compute.
