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—for example, bonds and contractual debt—now and in the future. It is commonly used by to ascertain 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 can't make the payments, it could go bankrupt and cease to exist. 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 off the income statement and divide it by the interest expense (I) also off the income statement.
Times interest earned = EBIT/I = Number of Times
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 ratios. For instance, if the number or 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 lack 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 consideration process. 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, so 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.