Times Interest Earned Ratio
Times interest earned (also called interest coverage ratio) is the ratio of earnings before interest and tax (EBIT) of a business to its interest expense during a given period. It is a solvency ratio measuring the ability of a business to pay off its debts.
Times interest earned ratio is calculated 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 tax (EBIT) is same as operating income.
Higher value of times interest earned ratio is favorable meaning greater ability of a business to repay its interest and debt. Lower values are unfavorable. A ratio of 1.00 means that income before interest and tax of the business is just enough to pay off its interest expense. That is why times interest earned ratio is of special importance to creditors. They can compare the debt repayment ability of similar companies using this ratio. Other things equal, a creditor should lend to a company with highest times interest earned ratio. It is also beneficial to create a trend of times interest earned ratio.
Example 1: Calculate the times interest earned ratio of a company having interest expense and earnings before interest and tax for the year ended Dec 31, 2010 of $239,000 and $3,493,000 respectively.
Times Interest Earned = $3,493,000 ÷ $239,000 ≈ 14.6
Example 2: The times interest earned ratio and earnings before interest and tax of a company were 9.34 and $1,324,400 during the year ended Jun 30, 2011. Calculate the interest expense of the company.
Interest Expense = $1,324,400 ÷ 9.34 ≈ $141,800