Times Interest Earned Ratio
Times interest earned ratio is an indicator of a company’s ability to pay off its interest expense with available earnings. It calculates how many times a company’s operating income (earnings before interest and taxes) can settle the company’s interest expense. A higher times interest earned ratio indicates that the company’s interest expense is low relative to its earnings before interest and taxes (EBIT) which indicates better long-term financial strength, and vice versa.
Times interest earned ratio is a measure of a company’s solvency, i.e. its long-term financial strength. It can be improved by a company's debt level, obtaining loans at lower interest rate, increasing sales, reducing operating expenses, etc.
Even though some practitioners refer to times interest earned ratio as interest coverage ratio, the interest coverage ratio is subtly different in that it is based on cash flows from operations instead of EBIT.
Other financial ratios which are similar in concept to the times interest earned ratio but wider in scope and more conservative in nature include fixed charge coverage ratio and EBITDA coverage ratio.
Time interest earned ratio is calculated by dividing earnings before interest and tax (EBIT) for a period with interest expense for the period as follows:
|Times Interest Earned =||Earnings before Interest and Tax|
Both figures in the above formula can be obtained from the income statement of a company.
Earnings before interest and taxes (EBIT) is used in the formula because generally a company can pay off all of its interest expense before incurring any income tax expense.
The ratio is reported as a number instead of a percentage.
Whenever a creditor lends money, he assesses the likelihood of its repayment: repayment of principal and interest. While debt ratio indicates total debt exposure relative to total assets, times interest earned (TIE) ratio assesses whether the company is earning enough to pay off the associated interest expense.
Higher value of times interest earned (TIE) ratio is favorable as it shows that the company has sufficient earnings to pay off interest expense and hence its debt obligations. Lower values highlight that the company may not be in a position to meet its debt obligations.
Times interest earned (TIE) ratio should be analyzed in the context of a company’s industry and together with other solvency ratios such as debt ratio, debt to equity ratio, etc.
Trend analysis using the times interest earned (TIE) ratio provides insight into a company’s debt-paying ability over time.
You are a Corporate Relationship Manager at EW Bank. You recently received applications from two FMCG companies, A & B, for 5-year financing. Your segment head has asked you to do some preliminary ratio analysis to assess whether the companies’ financial strength is good enough to warrant a detailed cash flows based analysis.
Following are excerpts from their balance sheets and income statements:
|Company A||Company B|
|Total liabilities||15 million||30 million|
|Total assets||30 million||40 million|
|Earnings before interest and taxes (EBIT)||2.5 million||2 million|
|Interest expense||1 million||1.5 million|
We can assess the solvency of the companies by calculating and comparing debt ratio and times interest earned ratio for both the companies, which are as follows:
Debt ratio of Company A = 15 million/30 million = 0.50
Debt ratio of Company B = 30 million/40 million = 0.75
Times interest earned ratio of Company A = 2.5 million/1 million = 2.5
Times interest earned ratio of Company B = 2 million/1.5 million = 1.33
The ratios indicate that Company A has better financial position than Company B, because currently 50% of its total assets are financed by debt (as compared to 75% in case of Company B). Further, Company A is better at paying off its interest expense as indicated by its times interest earned ratio of 2.5 (as compared to 1.33 in case of Company B), which means that the Company A can bear an interest expense 2.5 times its current interest expense while Company B can barely pay off its current interest expense.
Company B may not be in a position to take on any additional debt obligations.
by Irfanullah Jan, ACCA and last modified on