It is the measure of a company’s ability to meet the debt obligations based on its current income. It is also referred to as the interest coverage ratio; the times interest earned ratio is expressed as income before interest and taxes divided by interest expense.
It is usually expressed as a ratio and the numbers necessary to calculate the interest coverage ratio. They can be quickly taken from the company’s income statement.
To give you a clear understanding of times interest earned ratio, let’s say that the value is 4. What does it mean?
It implies that the company will meet its long-term debt four times over or that the income generated from their operations is four times higher than the debt that they owe.
How To Calculate The Times Interest Earned Ratio?
The times interest earned ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its periodic interest expense.
The interest cover formula is as follows:
TIE ratio= Earnings before interest and taxes/Interest expense
EBIT represents the profits that the business has got before paying taxes and interest.
Interest expense- The periodic debt payment that a company is legally obligated to pay to its creditors.
Both the above figures can be found in the income statement.
Usually, a higher times interest earned ratio is considered to be a good thing. But if the balance is too high, it could also mean that the company is hoarding all the earnings without putting them back into the company’s operations. For sustained growth for the long term, businesses must reinvest in the company.
If a business has a net income of $85,000, taxes to pay is around $15,000, interest expense is $30,000, then this is how the calculation goes.
Times Interest Earned Ratio= ($85,000+ $15,000 + $30,000)/($30,000)= 4.33.
In this case, the times interest earned ratio is 4.33. This ratio implies that the company can meet its debt obligations 4.33 times.
Understanding Times Interest Earned Ratio
One of the main factors is the company’s decision to look for debt or issue the stock for capitalization purposes. A business that makes a consistent annual income will be able to maintain debt as a part of its total capitalization. Creditors or investors who look at your income statement will be more than happy to lend to a business that has been consistently making enough money over a long period of time.
To give you an example, businesses that sell utility products regularly make money as their customers want their product. Most of these companies are usually funded by debt. Debtors are also happy to pay because they earn cash consistently.
But in the case of startups and other businesses which do not make money regularly, they usually issue stocks for capitalization. They will start funding their capital through debt offerings when they show that they can make money.
Is Times Interest Earned Ratio Important For Every Business?
If you are a small business that has a limited amount of debt, then the ratio is not at all necessary. It will not provide any insight into your business either.
When does it gain importance? If your business has debt and you are looking to take on more doubt, then the interest coverage ratio will provide your potential lenders with an understanding of how risky a business you are. It will tell them whether you would pay back the money that they are lending you.
Just like any other accounting ratio, it is best advised not to compare your score against other businesses but only with those who are in the same industry as you. It might not be necessary for you to calculate your times interest earned ratio, but when you are looking for funding from other companies, you will be calculating times interest earned ratio on a regular basis.
What Does A High Times Interest Earn Ratio Mean?
When the company has a high times interest earned ratio, it means that the company is in good hands. If investors are looking to put more cash into your account, they will be happy to find that the TIE ratio figure is high. It also presents a lower risk for creditors in terms of solvency.
A higher times interest earned ratio could indicate the following:
- Their operations are much more profitable than any of its peers, which will also result in more profits.
- A company that uses debt only for a small part of its capital structure will show a higher times interest earned ratio. On the other hand, a company that uses a large amount of its capital as debt will have a low times interest earned ratio because of the high interest rates that they would incur.
Let’s say that the times interest earned ratio is 3; that’s an acceptable risk for the investors. Businesses that have a times interest earned ratio of less than 2.5 are considered to be financially unstable.
Just because a company has a high times interest earned ratio, it doesn’t necessarily mean that they are able to manage their debts effectively. If the times interest earned ratio is exceptionally high, it could also mean that the business is not using the excess cash smartly. Instead, it is frivolously paying its debts far too quickly than necessary.
Is it possible to have a negative times interest earned ratio?
Of course. If you are reporting a loss, then your times interest earned ratio will be negative. When you have a net loss, the times interest earned ratio is certainly not the optimal ratio that you need to be concentrating on.
Advantages Of Using Times Interest Earned Ratio
- It will be helpful to compare two different companies in terms of how financially stable they are
- Simple to understand. If the ratio is low, it means that they are closer to filing for bankruptcy
- The ratio is easy to calculate as the figures required for it are available in the income statement
- It is an indicator of the long-term financial strength of an organization
Limitations Of Using Times Interest Earned Ratio:
- It only focuses on the short-term ability of the business to meet the interest payment.
- The interest expense number is usually an accounting calculation and need not be reflective of the actual interest expenses.
- It does not take into account any upcoming principal payment. Even if the business were to face a sizeable principal payment, times interest earned ratio doesn’t show it.
- If most of the business sales run on credit, then the ratio may come low even if the business has significantly positive cash flows
How To Overcome The Limitations Of Times Interest Earned Ratio?
To ensure that you are getting the real cash position of the company, you need to use EBITDA instead of earnings before interests and taxes.
EBITDA stands for earnings before interest, taxes, depreciation and amortization. If you want an even more clearer picture in terms of cash, you could use Times Interest Earned (cash basis). It is similar to times interest earned ratio, but it uses adjusted operating cash flow instead of EBIT. When you use this, you are considering the actual cash that the business has to meet its debt obligations.
How To Improve The Times Interest Earned Ratio?
Here are a few steps to consider:
#1 Increase Earnings
While it is easier said than done, if the business can manage to increase its earnings, then the interest coverage ratio gets better. The company will be able to increase its sales which will help boost earnings before interest and taxes. It will automatically improve the times interest earned ratio.
#2 Decrease Expenses
The opposite of increasing earnings is to reduce one’s expenses. If the company could find out areas where costs could be cut, it will significantly add to their bottom line. Streamlining their operations and looking for ways to cut costs on a 360-degree front will make it work. When you go out of your way to consistently weed out expenses that can be avoided, you will find that your interest coverage ratio is also getting better.
#3 Pay The Debts
When the company is able to reduce the debt of its balance sheet, the interest rates will significantly reduce. Paying off the debt at one go might not sit well with your lenders as they were hoping to get interest. So you need to look at the terms outlined in your agreement and the type of debt so that you can reduce your debt significantly. When you do so, it will reduce the company’s interest payments, thus making the interest coverage ratio much better.
#4 Consider Refinancing To Lower Interest Rates
If the agreement allows for it, you can change your financiers and go to a different lender. Make sure that you renegotiate your interest rates to an even better rate than what you were getting earlier. By doing this, you will be able to reduce the payments that you should be made to the lender. You will be in a position to have a much better interest coverage ratio.
#5 Reduce Instances Of Frauds
Ensure that the company is in compliance with all the local laws that you are governed under. This will protect you against any fines that you might have to fork over for not complying. Apart from this, the business also needs to ensure that there are no chances for frauds to occur. When frauds occur, it will result in a huge loss to the company, which will also affect its ability to pay off its debts. On top of this, it can seriously affect the relationship with the customers when they know about the fraud.
The times interest earned ratio measures the ability of a company to take care of its debt obligations. The better the ratio, it implies that the company is in a decent position financially, which means that they have the ability to raise more debt. But it should not be the only metric that lenders should use to decide if the company is worth lending to. There are so many other factors like the debt-equity ratio and the market conditions which should be used to assess before lending.
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