For example, if you have any current outstanding debt, you’re paying interest on that debt each month. While it is easier said than done, you can improve the interest coverage ratio by improving your revenue. The company will be able to increase its sales which will help boost earnings before interest and taxes.
- The Times Interest Earned (TIE) ratio measures a company’s ability to meet its debt obligations periodically.
- Investors use this metric when a company has a high debt burden to analyze whether a company can meet its debt obligations.
- The Times Interest Earned (TIE) ratio measures a company’s ability to meet its debt obligations on a periodic basis.
- Deducting depreciation and amortization from the EBIT amount in the numerator is a variant of the times interest earned ratio.
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. It is important to understand the concept of “Times interest earned ratio” as it is one of the predominantly financial metrics used to assess the financial health of a company.
Times Interest Earned Ratio (TIE)
While a company might have more than enough revenue to cover interest payments, it may be facing principal obligations coming due that it won’t be able to pay for. If the company doesn’t earn consistent revenue or experiences an unusual period of activity, this period will distort the realistic operations of the business. This is also true for seasonal companies that may generate unfairly low calculations during slower seasons. To calculate the times interest earned ratio, we simply take the operating income and divide it by the interest expense.
Let us take the example of a company that is engaged in the business of food store retail. During the year 2018, the company registered a net income of $4 million on revenue of $50 million. Further, the company paid interest at an effective rate of 3.5% on an average debt of $25 million along with taxes of $1.5 million. Calculate the retirement readiness checklist of the company for the year 2018. Total Interest Payable is all debt payments a company is required to make to creditors during the same accounting period. A corporation with an overly high TIE ratio, on the other hand, may suggest a lack of productive investment by the company’s management.
The TIE ratio is used when a company decides to look for debt or issue the stock for capitalization purposes. This company should take excess earnings and invest them in the business to generate more profit. A ratio of less than one suggests that a company may be unable to meet its interest obligations and is thus more likely to default on its debt; a low ratio is also a significant signal of probable bankruptcy. The amount of interest expenditure in the formula’s denominator is an accounting calculation that may include a discount or premium on the sale of bonds. So, it 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.
Relevance and Use of Times Interest Earned Ratio Formula
A times interest earned ratio of 2.15 is considered good because the company’s EBIT is about two times its annual interest expense. This means that the business has a high probability of paying interest expense on its debt in the next year. As a TIE financial ratio example, a company’s TIE ratio is computed as EBIT (earnings before interest and taxes) divided by annual interest expense on debt. The times interest earned ratio (TIE) is calculated as 2.15 when dividing EBIT of $515,000 by annual interest expense of $240,000. A business can choose to not utilize excess income for reinvestment in the company through expansion or new projects, but rather pay down debt obligations. For this reason, a company with a high times interest earned ratio may lose favor with long-term investors.
It could imply that a firm is not utilizing excess income into re-investment opportunities through new projects or expansions. As a result, long-term investors may lose favor with companies with high TIE ratios. The times interest earned (TIE) ratio 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. Although a higher times interest earned ratio is favorable, it does not necessarily mean that a company is managing its debt repayments or its financial leverage in the most efficient way.
What a High Times Interest Earned Ratio Can Tell You
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. This presents less of a risk to creditors and investors regarding solvency. From a creditors’ or investors’ point of view, a company with a TIE ratio greater than 2.5 is an acceptable risk. Organizations with less than 2.5 normally have higher chances of defaulting or bankruptcy; thus, considered financially unstable. Keep in mind that small businesses or start-ups with limited debt amounts do not need to worry about TIE ratios because it does not offer any insight into the entities.
Consequently, 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. As a result, the interest earned ratio formula is used to evaluate a company’s ability to meet its debt and evaluate the company’s cash flow health. In a nutshell, it’s a measure of a company’s ability to meet its “debt obligations” on a “periodic basis”.
Understanding the Times Interest Earned (TIE) Ratio
However, a high ratio can also indicate that a company has an undesirable or insufficient amount of debt or is paying down too much debt with earnings that could be used for other projects. A higher times interest earned ratio is favorable because it means that the company presents less risk to investors and creditors in terms of solvency. From an investor or creditor’s perspective, an organization with a times interest earned ratio greater than 2.5 is considered an acceptable risk. Companies with a times interest earned ratio of less than 2.5 are considered a much higher risk for bankruptcy or default and, therefore, financially unstable. A good TIE ratio is at least 2 or 3, especially in economic times when EBIT can fall due to revenue drops and cost inflation effects, and interest expense rises on variable rate debt as the Fed raises rates. The relatively high TIE ratio means the company’s EBIT is 2 to 3 times its annual interest expense, which is a margin of safety for the risk of making interest payments on debt.
If you record a net loss, your times interest earned ratio will also be negative. If your company has a net loss, the times interest earned ratio is usually not the optimum ratio to compute. Times interest earned can be a useful financial ratio, especially if analyzed in conjunction with a series of other financial metrics in analyzing the financial health of a company.
What Is the Times Interest Earned Ratio?
You need to have a proper strategy to pay off debts on time while growing the entity and remaining profitable at the same time. The times interest ratio is expressed numerically rather than as a percentage. The ratio reveals how many times a corporation might pay interest with its pre-tax income. For example, if a company owes interest on its long-term loans or mortgages, the TIE can measure how easily the company can come up with the money to pay the interest on that debt. On the other hand, startups and businesses that have inconsistent earnings raise most or all of the capital they use by issuing stock.
According to LeaseQuery, financial leases have interest expense but it’s not considered an operating expense, and, therefore, not included in the calculation of EBITDA [and EBIT]. And companies report interest expense related to operating leases as part of lease expense rather than as interest expense. In other words, a ratio of 4 means that a company makes enough income to pay for its total interest expense 4 times over.
Importance of Times Interest Earned Ratio
Here, we can see that Harrys’ TIE ratio increased five-fold from 2015 to 2018. This indicates that Harry’s is managing its creditworthiness well, as it can continually increase its profitability without taking on additional debt. If Harry’s needs to fund a major project to expand its business, it can viably consider financing it with debt rather than equity. The TIE’s primary purpose is to help quantify a company’s probability of default. This, in turn, helps determine relevant debt parameters such as the appropriate interest rate to be charged or the amount of debt that a company can safely take on. When the interest coverage ratio is smaller than one, the company is not generating enough cash from its operations EBIT to meet its interest obligations.
That all changed in 2019, when Harold took out a high-interest-rate loan to help cover employee expenses. Businesses with a TIE ratio of less than two may indicate to investors and lenders a higher probability of defaulting on a future loan, while a TIE ratio of less than 1 indicates serious financial trouble. In theory, a Times Interest Earned Ratio of 2.5 or higher is considered acceptable, and a TIER of less than 2.5 suggests that a company’s debt burden may be too high. Keep in mind that not all companies have debt, and as a result, not all companies will have an interest expense.
In contrast, for Company B, the TIE ratio declines from 3.2x to 0.6x in the same time horizon. While there aren’t necessarily strict parameters that apply to all companies, a TIE ratio above 2.0x is considered to be the minimum acceptable range, with 3.0x+ being preferred. As a general rule of thumb, the higher the TIE ratio, the better off the company is from a risk standpoint. Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent. Our second example shows the impact a high-interest loan can have on your TIE ratio.