What is Times Interest Earned Ratio
The times interest earned ratio, also known as the interest coverage ratio, is a coverage ratio that calculates the proportion of revenue that may be used to cover future interest expenses.
The times interest ratio is regarded as a solvency ratio in certain ways since it reflects a company’s capacity to make interest and debt service payments.
Because these interest payments are normally made over a lengthy period of time, they are sometimes viewed as an ongoing, fixed expenditure.
If the firm is unable to make the payments, it may go bankrupt and cease to exist, as is the case with most fixed costs. As a result, this ratio might be regarded as a solvency ratio.
Times Interest Earned Interpretation
To further comprehend the TIE, consider a times interest earned ratio explanation of what this figure truly implies. The TIE may be thought of as a solvency ratio since it measures how readily a company can meet its financial obligations. Because interest payments are set long-term costs, they are employed as the measure.
If a company struggles to pay fixed expenditures such as interest, it faces the danger of going bankrupt. In this approach, the ratio delivers an early indicator that a firm might need to pay off existing debts before taking on additional debt.
The TIE particularly assesses how many times a company’s interest expenditures may be covered in a certain period. While it is unnecessary for a corporation to be able to pay its obligations 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, since it may invest in new equipment or fund expansions. When the firm has money to put back into the business, it’s apparent that it’s doing well.
Times Interest Earned Formula
The times interest earned ratio compares a company’s operating income (EBIT) to the amount of interest expense owing on its debt commitments.
The TIE ratio of a corporation is calculated by dividing the company’s EBIT by the total interest expenditure on all debt instruments.
Times Interest Earned (TIE) = EBIT / Interest Expense
The resulting ratio illustrates how many times a company’s interest expenditure might be paid off using its operating revenue. Other variants of the TIE ratio might employ EBITDA instead of EBIT in the numerator.
A high interest earned ratio indicates that the firm has sufficient cash to make its interest payments and can continue to reinvest in its activities to produce continuous profits.
A high TIE ratio indicates a company’s trustworthiness as a borrower and its ability to absorb underperformance owing to the significant cushion (to pay debt commitments) supplied by its cash flows.
A lower times interest earned ratio, on the other hand, indicates that the corporation has less tolerance for mistakes and may be at danger of default.
Times Interest Earned Ratio Calculation
The TIE Ratio may be calculated using the following formula:
Earnings Before Interest and Taxes (EBIT) / Interest Expense = Times Interest Earned (TIE) Ratio
Where EBIT is the operational profit calculated as Net Sales minus operating expenditures, and Interest Expense is the total debt repayment that a firm is required to pay to its creditors.
Company ABC, for example, has reported the following:
EBIT = $350,000
Expenses for Total Interest = $50,000
Company ABC wants to increase its activities by acquiring additional machinery for their factory.
To finance the growth, they will need to incur debt in order to do so.
Based on the data presented above, Company ABC’s TIE Ratio may be calculated as follows:
TIE Ratio = $350,000 / $50,000
TIE Ratio = 7
If a bank looked at Company ABC’s books, they would see that the company can afford to pay its interest 7 times over.
However, if the corporation in the above example had a total interest expense of $200,000, its TIE Ratio will be ($350,000 /$200,000) = 0.625.
A ratio of less than 1 indicates to lenders that a firm is most likely to fail on its debt.
What is a Good Times Interest Earned Ratio?
An investor or creditor considers a firm with a times interest earned ratio greater than 2 or 2.5 to be an acceptable risk. Companies with a times interest earned ratio less than 2 are seen to be at a significantly higher risk of insolvency or default, and so financially unstable.
At the same time, if the times interest earned ratio is very high, investors may conclude that the firm is extremely risked conservative. Although it is not incurring debt, it is not reinvesting its profits in business expansion. This circumstance may also necessitate prudence.
In other words, the firm is not overextending itself, but it may not be reaching its full potential for development. The TIE ratio, like any other measure, should be viewed in conjunction with other financial indicators and margins.
Can Times Interest Earned be Negative?
A negative times interest earned ratio shows that the corporation is losing money rather than making money. It indicates the corporation is facing a significant financial crisis.
Limitation of Times Interest Earned
This ratio has a number of flaws, which are as follows:
The EBIT value in the formula’s numerator is an accounting computation that does not always correspond to the amount of cash earned. As a result, while the ratio may be good, a company may not have enough cash to cover its interest rates.
The inverse situation might also occur, in which the ratio is relatively low despite the fact that the borrower has considerable positive cash flows.
The amount of interest expenditure in the formula’s denominator is an accounting figure that may include a discount or premium on the sale of bonds, and so 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.
The ratio does not account for any upcoming 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.
In addition, to the times interest earned ratio, depreciation and amortization are deducted from the EBIT amount in the numerator.
Depreciation and amortization, on the other hand, are indirectly related to a business’s requirement to acquire fixed assets and intangible assets on a long-term basis, and so may not reflect money available for the payment of interest expense.
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