Times interest earned is the ratio between earnings before interest and taxes and the interest expenses of the company over that specific period; it helps in determining the liquidity position of the company by determining whether they are in a comfortable position to pay interest on its outstanding debt.
What is Times Interest Earned Ratio?
Times interest earned ratio is a solvency ratio which measures the ability of an organization to pay its debt obligations. Also known as interest coverage ratio the lenders commonly use it to ascertain if the borrower can take on additional loan.
- Times Interest ratio is calculated by dividing the earnings of the Company before it pays interest by the interest expense or the ratio is a division of simply Earnings Before interest and tax to interest expense.
- We note from the above chart that Volvo’s Times Interest Earned has been steadily increasing over the years. This is a good situation to be in due to the company’s increased capacity to pay the interests.
- Analysts should consider a time series of the ratio. A single point ratio may not be very good measure as it may include onetime revenue or earnings. Companies with consistent earnings will have the consistent ratio over a period of time thus indicating its better position to service debt.
- However, smaller Companies and startups which do not have consistent earnings will have a variable ratio over time. Thus, lenders do not prefer to give loans to such Companies. Hence, these Companies have higher equity and raise money from Private equity and venture capitalists.
How to use Times Interest Earned Ratio?
- Clearly, the ratio gives how many times the Company can cover its interest expense to its pre-tax and pre-interest earnings.
- The banks and financial lenders often look at various financial ratios to determine the solvency of the Company and whether it will be able to service its debt before taking on more debt. The banks look at debt ratio, debt-equity ratio and Times interest earned ratio often.
- The debt ratio and debt to equity ratio is a measure of the capital structure of the Company and indicates the exposure of the Company to debt financing relative to total assets or equity respectively. However, this ratio measures if the Company is earning enough to pay off the interest.
- High times interest earned ratio is favorable as it indicates the Company is earning higher than it owes and will be able to service its obligations whereas lower values indicate the Company may not be able to fulfill its obligations.
Please note that many analyst’s use EBITDA in the numerator instead of EBIT (which I think is absolutely fine if you use it consistently over the years).
Thus, the new ratio becomes:
- Times interest earned ratio = Earnings before Interest, tax, depreciation, and amortization/Interest expense
This is done because depreciation and amortization expenses are accounting figures and are not actual cash outflows for the given period. Thus, removing such expenses reflects better earnings or capacity of the Company to pay the interest expense. However, arguably the depreciation and amortization expense indirectly relates to future business needs to buy fixed and intangible assets and thus, the funds may not be available for the payment of interest expense.
Times Interest Earned Ratio Example
Let us look at Times Interest Earned Ratio Calculation
Suppose there are two Companies, Alpha, and beta in a similar industry. The two companies have below mentioned financials:
- TIE by Company alpha = EBIT/interest expense = 15/5 = 3
- TIE by Company beta = EBIT/interest expense = 10/7 = 1.42
In the above example, we can see Company alpha has a higher times interest earned ratio than Company beta. Thus, relatively Company alpha is in better financial position than Company beta and the lenders will be more willing to give additional debt to alpha than to Company beta.
However, the times to interest ratio of Company beta is greater than 1 which indicates that it generates sufficient earnings to cover more interest payments. Thus, the lenders may look at other factors like debt ratio, debt-equity ratio, industry standards etc. to decide.
Companies with times interest ratio of less than 1 are unable to service their debt. They cannot meet their interest requirements from their earnings and must dig into their reserves to pay their obligations.
- It is easy to calculate times interest earned ratio
- The ratio is indicative of solvency of the Company
- The ratio can be used as an absolute measure of the financial position of the Company
- The ratio can be used as a relative measure to compare two or more Companies
- The negative ratio indicates that the Company is in serious financial trouble
Although a good measure of solvency, the ratio has its disadvantages. Let us have a look at the flaws and disadvantages of calculating Times interest earned ratio:
- Earnings Before Interest and tax used in the numerator is an accounting figure which may not be representative of enough cash generated by the Company. The ratio could be higher but this does not indicate the Company has actual cash to pay the interest expense
- The amount of interest expense used in the denominator of the ratio is again an accounting measurement. It may include a discount or premium on the sale of the bonds and may not include the actual interest expense to be paid. To avoid such issues, it is advisable to use the interest rate on the face of the bonds.
- The ratio only considers the interest expenses. It does not account for principal payments. The principal payments may be huge and lead the Company to insolvency. Further, the Company may be bankrupt or may have to refinance at the higher interest rate and unfavorable terms. Thus, while analyzing the solvency of the Company other ratios like debt equity and debt ratio should also be considered.
Times interest earned ratio measures the Company’s solvency and its ability to service its debt obligations. The ratio is indicative of the number of times the earnings to the interest expenses of the Company. Higher the ratio better is the financial position of the Company and it is a better candidate to raise more debt. A ratio of more than 1 is favorable however lenders should not rely on the ratio alone to decide. Other factors and ratios like debt ratio, debt-equity ratio, industry and economic conditions should be considered before lending.
Times Interest Earned Ratio Video
This has been a guide to what is Times Interest Earned Ratio and its meaning. Here we discuss how to use Times Interest Earned ratio along with practical examples, advantages, and disadvantages. You may learn more about ratio analysis from the following articles –
- Total Equity Formula | Examples | Explanation
- Limitations of Coverage Ratios
- The Significance of Equity Ratio Calculation
- Financial Ratios | Top 28 Types
- Importance and uses of Ratio Analysis
- What are Negative Covenants (Restrictive)?
- Debt Covenants
- Return on Equity Formula
- Return on Capital Employed (ROCE)
- Return on Assets Formula