There are a number of metrics to assess a company’s financial health. The times interest earned ratio is one example. Here’s everything you need to know, including how to calculate the times interest earned ratio.
Understanding the times interest earned ratio
The times interest earned (TIE) ratio, also known as the interest coverage ratio, measures how easily a company can pay its debts with its current income. To calculate this ratio, you divide income by the total interest payable on bonds or other forms of debt. After performing this calculation, you’ll see a number which ranks the company’s ability to cover interest fees with pre-tax earnings. Generally, the higher the TIE, the more cash the company will have left over.
Times interest earned ratio explanation
To better understand the TIE, it’s helpful to look at a times interest earned ratio explanation of what this figure really means. You could look at the TIE as a solvency ratio, because it measures how easily a business can fulfil its financial obligations. Interest payments are used as the metric, since they are fixed, long-term expenses. If a business struggles to pay fixed expenses like interest, it runs the risk of going bankrupt. In this way, the ratio gives an early indication that a business might need to pay off existing debts before taking on more.
The TIE specifically measures how many times a company could cover its interest expenses during a given period. While it’s unnecessary for a company to be able to pay its debts more than once, when the ratio is higher it indicates that there’s more income left over. A higher discretionary income means the business is in a better position for growth, as it can invest in new equipment or pay for expansions. It’s clear that the company’s doing well when it has money to put back into the business.
How to calculate times interest earned ratio
To use the times interest earned ratio formula, you’ll first need to calculate the company’s earnings before interest and taxes, or EBIT. You can find this information on the income statement. Once you’ve located the EBIT, the times interest earned ratio formula is:
TIE Ratio: EBIT / Interest Expense
EBIT represents all profits that the business has taken in for the accounting period in question, without factoring in any tax payments, interest, or other elements.
Interest expense represents any debt payments that the company’s required to make to creditors during this same period. Like EBIT, this information will also be found on the income statement.
Times interest earned ratio example
For an example of how this looks in practice, imagine that Company A is in the market for a new loan to buy machinery. Before issuing the loan, the bank looks over the company’s income statement. It shows that Company A took in £400,000 in income before interest expenses and taxes. During this same tax year, Company A paid £20,000 in interest expenses or debts. The calculation would look like this:
TIE Ratio for Company A = £400,000 / £20,000
The TIE would therefore be 20, meaning that Company A’s income is 20 times greater than the annual interest expense. This indicates that there is little risk in issuing the loan.
What is a good times interest earned ratio?
The example above, 20, is a high times interest earned ratio. There’s no perfect answer to “what is a good times interest earned ratio?” because the answer will depend on the type of business and industry. It’s more important to think about what the ratio signifies for a business, showing the number of times over it can pay its interest.
At the same time, if the times interest earned ratio is too high, it could indicate to investors that the company is overly risk averse. Although it’s not racking up debt, it’s not using its income to re-invest back into business development. This situation could warrant caution as well. In other words, the company’s not overextending itself, but it might not be living up to its growth potential. Like any metric, the TIE ratio should be looked at alongside other financial indicators and margins.
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