The Times Interest Earned Ratio and What It Measures
The times interest earned (TIE) ratio, sometimes called the interest coverage ratio or fixed-charge coverage, is another debt ratio that measures the long-term solvency of a business. It measures the proportionate amount of income that can be used to meet interest and debt service expenses (e.g., bonds and contractual debt) now and in the future. It is commonly used to determine whether a prospective borrower can afford to take on any additional debt.
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.
In some respects, the times interest earned ratio is considered a solvency ratio. Since interest and debt service payments are usually made on a long-term basis, they are often treated as an ongoing, fixed expense. As with most fixed expenses, if the company is unable to make the payments, it could go bankrupt, terminating operations. Thus, this ratio could be considered a solvency ratio.
The times interest earned ratio is calculated by dividing the income before interest and taxes (EBIT) figure from the income statement by the interest expense (I) also from the income statement.
Times interest earned ratio = EBIT or Income before Interest & Taxes / Interest Expense
The times interest earned ratio is stated in numbers as opposed to a percentage, with the number indicating how many times a company could pay the interest with its before-tax income. As a result, larger ratios are considered more favorable than smaller ones. For instance, if the ratio is 4, the company has enough income to pay its interest expense 4 times over. Said differently, the company's income is four times higher than its yearly interest expense.
The higher the number, the better the firm can pay its interest expense or debt service. If the TIE is less than 1.0, then the firm cannot meet its total interest expense on its debt. 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.
Joe's Excellent Computer Repair is applying for a loan, and the bank wants to see the company's financial statements as part of the application process. As a part of the qualification process, creditors (e.g., banks and other lending institutions) assess the likelihood that the borrower will be able to repay the loan, principal and interest. Using the times interest earned ratio is one indicator that the company can or cannot fulfill the obligation. The statement shows $50,000 in income before interest expenses and taxes.
The company's overall interest and debt service for the year amounted to $5,000; therefore, the calculation would be:
$50,000 / $5,000 = 10 Times
Thus, Joe's Excellent Computer Repair has a times interest earned ratio of 10, which means that the company's income is 10 times greater than its annual interest expense, and the company can afford the interest expense on this new loan. In this respect, Joe's Excellent Computer Repair doesn't present excessive risk, and the bank will likely accept the loan application.