Times Interest Earned Ratio

Times interest earned ratio (also called interest coverage ratio) is an indicator of the company’s ability to pay off its interest expense with available earnings. It is a measure of a company’s solvency, i.e. its long-term financial strength. It calculates how many times a company’s operating income (earnings before interest and taxes) can settle the company’s interest expense. A higher times interest earned ratio indicates that the company’s interest expense is low relative to its earnings before interest and taxes (EBIT) which indicates better long-term financial strength, and vice versa.

Formula

Time interest earned ratio is calculated by dividing earnings before interest and tax (EBIT) for a period with interest expense for the period as follows:

Times Interest Earned =Earnings before Interest and Tax
Interest Expense

Both figures in the above formula can be obtained from the income statement of a company.

Earnings before interest and taxes (EBIT) is used in the formula because generally a company can pay off all of its interest expense before incurring any income tax expense.

The ratio is reported as a number instead of a percentage.

Analysis

Whenever a creditor lends money, he assesses the likelihood of its repayment: repayment of principal and interest. While debt ratio indicates total debt exposure relative to total assets, times interest earned (TIE) ratio assesses whether the company is earning enough to pay off the associated interest expense.

Higher value of times interest earned (TIE) ratio is favorable as it shows that the company has sufficient earnings to pay off interest expense and hence its debt obligations. Lower values highlight that the company may not be in a position to meet its debt obligations.

Times interest earned (TIE) ratio should be analyzed in the context of a company’s industry and together with other solvency ratios such as debt ratio, debt to equity ratio, etc.

Trend analysis using the times interest earned (TIE) ratio provides insight into a company’s debt-paying ability over time.

Example

You are a Corporate Relationship Manager at EW Bank. You recently received applications from two FMCG companies, A & B, for 5-year financing. Your segment head has asked you to do some preliminary ratio analysis to assess whether the companies’ financial strength is good enough to warrant a detailed cash flows based analysis.

Following are excerpts from their balance sheets and income statements:

Company ACompany B
Total liabilities15 million30 million
Total assets30 million40 million
Earnings before interest and taxes (EBIT)2.5 million2 million
Interest expense1 million1.5 million

Solution

We can assess the solvency of the companies by calculating and comparing debt ratio and times interest earned ratio for both the companies, which are as follows:

Debt ratio of Company A = 15 million/30 million = 0.50

Debt ratio of Company B = 30 million/40 million = 0.75

Times interest earned ratio of Company A = 2.5 million/1 million = 2.5

Times interest earned ratio of Company B = 2 million/1.5 million = 1.33

The ratios indicate that Company A has better financial position than Company B, because currently 50% of its total assets are financed by debt (as compared to 75% in case of Company B). Further, Company A is better at paying off its interest expense as indicated by its times interest earned ratio of 2.5 (as compared to 1.33 in case of Company B), which means that the Company A can bear an interest expense 2.5 times its current interest expense while Company B can barely pay off its current interest expense.

Company B may not be in a position to take on any additional debt obligations.

Written by Irfanullah Jan