Business

What is the Times Interest Earned Ratio?

What is the Times Interest Earned Ratio

What is the Times Interest Earned Ratio? A company’s ability to meet its debt obligations on a periodic basis is assessed through the Times Interest Earned (TIE) ratio. A company’s EBIT can be calculated by dividing it by its periodic interest expense. The ratio shows the number of times that a company could, theoretically, pay its periodic interest expenses by allocating all of its EBIT to debt repayment.

TIE’s main purpose is to quantify a company’s risk of default. In turn, this provides relevant debt parameters such as the appropriate interest rate to charge or the amount of debt a company can comfortably take on.

An organization with a high TIE has a lower probability of defaulting on its loans, making it a safer investment for debt providers. As a result of a low TIE, a company has a greater chance of defaulting, as it has less money to devote to debt repayment.

How to Calculate the Times Interest Earned Ratio

The Times Interest Earned ratio can be calculated by dividing earnings before interest and taxes (EBIT) by periodic interest expense. The formula for calculating the ratio is:

TIE Ratio = Earnings Before Interest & Taxes/Interest Expense

Where:

Earnings Before Interest & Taxes (EBIT) – shows the profit realized by the business, excluding interest and taxes

Interest Expense – The periodic payments a company must make to its creditors

In general, the higher the TIE ratio, the better. However, a company’s excessively high TIE ratio may indicate a lack of productive investment by its management. When TIE is excessively high, the company may keep all of its earnings instead of investing in business development through positive NPV projects or by investing in research and development. The company may experience a lack of profitability and challenges related to sustained growth in the future.

Times Interest Earned Ratio Example

Harry’s Bagels wants to calculate its time’s interest earned ratio in order to get a better idea of its debt repayment ability.

Red boxes indicate the information we need to calculate TIE, namely EBIT and Interest Expense.

Harry’s TIE ratio increased five-fold from 2015 to 2018. The fact that Harry’s is able to increase its profitability without incurring additional debt indicates that it is managing its creditworthiness well. If Harry’s needs to fund a major project to expand its business, it should consider financing it with debt rather than equity.

A ratio should be calculated for a number of companies that operate in the same industry in order to better understand the financial health of the business. If other firms in this industry have TIE multiples that are lower than Harry’s, then we can conclude that Harry’s is managing its level of financial leverage more effectively. Therefore, creditors are more likely to lend to Harry’s, since the company represents a relatively safe investment in the bagel industry.

Problems with the Times Interest Earned Ratio

This ratio has several flaws, which are outlined below.

EBIT Does Not Match Cash

EBIT is an accounting calculation that does not necessarily relate to cash generated. As a result, the ratio might be excellent, but the company may not have sufficient cash to pay its interest charges. The reverse concern can also be true, where the ratio is quite low, even though a borrower actually has significant positive cash flows.

Interest May Include Discounts or Premiums

In the denominator of the formula, interest expense appears as an accounting calculation that may include a discount or premium on the sale of bonds. As a result, it does not represent the actual amount of interest expense to be paid. It is better to use the interest rate stated on the bonds in these cases.

Does Not Include Impending Principal Paydowns

The ratio does not account for any looming principal paydown. This could be large enough to bring about the bankruptcy of the borrower or at least force it to refinance at a higher rate of interest. In addition, it could be subject to more severe loan covenants than it currently has.

Incorrect Indication of Funds Availability

It is also possible to deduct depreciation and amortization from the EBIT figure in the numerator of the TIE ratio. Depreciation and amortization, which indirectly relate to a business’ need to purchase fixed assets and intangible assets over time, may not be available for paying interest expenses.

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