What Is the Times Interest Earned Ratio?
The times interest earned ratio (TIE) is a measure of a company’s ability to meet its debt obligations based on its current income. The formula for a company’s TIE number is earnings before interest and taxes (EBIT) divided by the total interest payable on bonds and other debt. The resulting number shows how many times a company can cover its interest charges with its pretax earnings. TIE is also referred to as the interest coverage ratio.
A company’s TIE indicates its ability to pay its debts. A higher number means a company has enough cash after paying its debts to continue to invest in the business. The formula for TIE is calculated as earnings before interest and taxes divided by total interest payable on debt. Companies that have consistent earnings, like utilities, tend to borrow more because they are good credit risks. As a result, utilities can survive and prosper with lower TIE numbers.
Understanding the Times Interest Earned (TIE) Ratio
Obviously, no company needs to cover its debts several times over in order to survive. However, the TIE ratio is an indication of a company’s relative freedom from the constraints of debt. Generating enough cash flow to continue to invest in the business is better than merely having enough money to stave off bankruptcy. A company’s capitalization is the amount of money it has raised by issuing stock or debt, and those choices impact its TIE ratio. Businesses consider the cost of capital for stock and debt and use that cost to make decisions. i
The TIE’s main purpose is to help quantify a company’s probability of default. This, in turn, helps determine relevant debt parameters. For example, the appropriate interest rate to be charged or the amount of debt that a company can safely take on. A high TIE means that a company likely has a lower probability of defaulting on its loans. This makes it a safer investment opportunity for debt providers. Conversely, a low TIE indicates that a company has a higher chance of defaulting. This is because it has less money available to dedicate to debt repayment.
Factoring in Consistent Earnings
As a rule, companies that generate consistent annual earnings are likely to carry more debt as a percentage of total capitalization. If a lender sees a history of generating consistent earnings, the firm will be considered a better credit risk. Utility companies, for example, generate consistent earnings. Their product is not an optional expense for consumers or businesses. Some utility companies raise 60% or more of their capital by issuing debt. Startup firms and businesses that have inconsistent earnings, on the other hand, raise most or all of the capital they use by issuing stock. Once a company establishes a track record of producing reliable earnings, it may begin raising capital through debt offerings as well.
(Source: investopedia.com & corporatefinanceinstitute.com)
Times Interest Earned Ratio Formula
The Times Interest Earned ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its periodic interest expense. The formula to calculate the ratio is:
Times Interest Earned = Earnings before Interest & Taxes (EBIT) / Interest Expense
- Earnings Before Interest & Taxes (EBIT) – represents profit that the business has realized, without factoring in interest or tax payments
- Interest Expense – represents the periodic debt payments that a company is legally obligated to make to its creditors
Generally speaking, the higher the TIE ratio, the better. However, a company with an excessively high TIE ratio could indicate a lack of productive investment by the company’s management. An excessively high TIE suggests that the company may be keeping all of its earnings without re-investing in business development through research and development or through pursuing positive NPV projects. This may cause the company to face a lack of profitability and challenges related to sustained growth in the long term.
Example Calculation – Times Interest Earned Ratio (TIE)
Assume, for example, that XYZ Company has $10 million in 4% debt outstanding and $10 million in common stock. The company needs to raise more capital to purchase equipment. The cost of capital for issuing more debt is an annual interest rate of 6%. The company’s shareholders expect an annual dividend payment of 8% plus growth in the stock price of XYZ. The business decides to issue $10 million in additional debt. Its total annual interest expense will be: (4% X $10 million) + (6% X $10 million), or $1 million annually. The company’s EBIT is $3 million. This means that the TIE ratio for XYZ Company is 3, or three times the annual interest expense.
Joe’s Excellent Computer Repair is applying for a loan, and the bank wants to see the company’s financial statements as part of the application process. As a part of the qualification process, creditors (e.g., banks and other lending institutions) assess the likelihood that the borrower will be able to repay the loan, principal, and interest. Using the times interest earned ratio is one indicator that the company can or cannot fulfill the obligation. The statement shows $50,000 in income before interest expenses and taxes.
The company’s overall interest and debt service for the year amounted to $5,000; therefore, the calculation would be: $50,000 / $5,000 = 10 Times
Thus, Joe’s Excellent Computer Repair has a times interest earned ratio of 10, which means that the company’s income is 10 times greater than its annual interest expense, and the company can afford the interest expense on this new loan. In this respect, Joe’s Excellent Computer Repair doesn’t present excessive risk, and the bank will likely accept the loan application.
The times interest ratio is stated in numbers as opposed to a percentage. The ratio indicates how many times a company can pay interest with its before-tax income. Therefore, larger ratios are considered more favorable than smaller ratios. In other words, a ratio of 4 means that a company makes enough income to pay for its total interest expense 4 times over. Said another way, this company’s income is 4 times higher than its interest expense for the year. As you can see, creditors favor a company with a much higher times interest ratio. This is because it shows the company can afford to pay its interest payments when they come due. Higher ratios are less risky while lower ratios indicate credit risk.
Problems with the Times Interest Earned Ratio
However, there are a number of flaws associated with this ratio, which are:
- EBIT does not necessarily reflect cash on hand – The EBIT figure noted in the numerator of the formula is an accounting calculation that does not necessarily relate to the amount of cash generated. Thus, the ratio could be excellent, but a business may not actually have any cash with which to pay its interest charges. The reverse situation can also be true, where the ratio is quite low, even though a borrower actually has significant positive cash flows.
- Interest expense can be misstated – The amount of interest expense appearing in the denominator of the formula is an accounting calculation. It may incorporate a discount or premium on the sale of bonds. As a result, it may not equate to the actual amount of interest expense that must be paid. In these cases, it is better to use the interest rate stated on the face of the bonds.
- Lump-sum debt payments may not be reflected – The ratio does not take account of any looming principal paydown. Sometimes, this could be large enough to bring about the bankruptcy of the borrower. Or, it could force it to refinance at a higher rate of interest. Or, refinance with more severe loan covenants than it currently has.
Also, a variation on the times interest earned ratio is to deduct depreciation and amortization from the EBIT figure in the numerator. However, depreciation and amortization indirectly relate to a business’ need to buy fixed assets and intangible assets on a long-term basis. So, it may not represent funds that are available for the payment of interest expense.
Times Interest Earned Ratio – Final Thoughts
The times interest earned ratio is not necessary for every business. If you’re a small business with a limited amount of debt, the times interest earned ratio will likely not provide any new insight into your business operations. However, if your business currently has debt, and you are considering taking on more, the times earned interest ratio provides you and potential creditors or investors with a snapshot of your business risk and how likely it is you’ll be able to pay back any funds that are offered. Like any accounting ratio, if comparing results to other businesses, be sure that you’re comparing your results to similar industries, as a TIE ratio of 3 may be adequate in one industry but considered low in another.
If you’re reporting a net loss, your times interest earned ratio would be negative as well. However, if you have a net loss, the times interest earned ratio is probably not the best ratio to calculate for your business.
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