Times Interest Earned Ratio
Many entrepreneurs cannot avoid debt when running a business. While it can be devastating for some, debt is not necessarily bad for your venture. You need to have a proper strategy to pay off debts on time while growing the entity and remaining profitable at the same time.
Regarding debt in your organization, it’s vital to consider the times interest earned ratio. Also known as interest coverage ratio or fixed-charge coverage, it is an accounting metric that business owners must be conversant with. Read on to learn what is the times interest earned ratio and other essential information on this ratio.
Understanding the Times Interest Earned (TIE) Ratio
We kick off the article by discussing times interest earned ratio meaning. The interest coverage ratio measures how borrowers or companies can cover the interest they owe on debt obligations based on current income. The ratio is critical in numerous business aspects, such as:
- The ratio indicates the extent to which your company’s earnings are available to meet interest or debt payments.
- It also shows whether a firm can still keep investing in its operations after servicing debt.
- A firm can also use this ratio to determine whether a firm is in a position to afford the additional debt.
- Investors use the ratio to determine the number of times a firm can pay its interest charges with earnings before tax.
- Companies can use the interest coverage ratio internally to make vital decisions on how best to finance the entity.
Naturally, a company does not have to pay its debts many times over. However, the TIE ratio indicates whether a company is financially healthy.
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. The ratio is more beneficial to firms that already have debt and are mainly looking to borrow more debt. TIE ratio offers potential lenders an understanding of how risky a company is. It lets lenders know if a candidate can pay back their borrowed money.
It’s also crucial to note times interest earned ratio interpretation in other aspects of business such as:
- Analysts should look into a time series of the ratio. Only considering a single point ratio may not give an accurate picture of earnings. Financial lenders and banks look at multiple financial ratios to determine a company’s solvency and whether or not it will service its debt effectively.
- Companies that are fortunate to get consistent earnings will have a constant ratio that shows they are better positioned to service debts. Conversely, some firms may not have consistent ratios, especially small companies or the ones starting out. Lenders looking at these ratios may decline to offer loans; hence such companies may have to consider venture capitalists or private equity to raise funds.
How to Calculate Times Interest Earned (TIE)
To calculate TIE, you use the following times interest earned ratio formula:
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Explanation of Times Interest Earned Formula
As aforementioned, you can use EBIT/ Total Interest Expense to learn how to find times interest earned ratio. It is a formula that is simple to use and calculate, as you will uncover in the explanation of the procedure below.
- The formula’s numerator has EBIT (earnings before interest and taxes). This covers a firm’s pre-tax operating income. It is the income your organization generates from business after deducting the necessary expenses that run the entity.
- On the other hand, the denominator covers the total interest due on a firm’s debt together with debts.
Remember that you can easily find the numbers on the denominator and numerator on a company’s income statement. When you divide EBIR by the total interest expenses, you will answer how many times a company is earning to meet its debt responsibilities.
The resulting ratio is normally stated as a number and not a percentage. For instance, a ratio of 5 indicates that a firm can meet interest payments on the debt they owe five times over. It may also suggest that the company’s income is five times higher than the interest expenses cost the firm owes that year.
Is a High Times Interest Earned Ratio Good?
A firm can either have a low, negative, or high-interest coverage ratio. A lower ratio implies a venture had fewer earnings to meet its loan obligations. A negative ratio indicates that an organization is in grave financial trouble because it is reporting a loss.
A higher TIE number is more favorable to your entity. It means that the firm is making enough cash to service its loans. 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.
A higher interest coverage ratio may also indicate that a firm’s operations are more profitable than their competitors. It could also mean that the venture only used debt for a minimal part of its capital structure. Some suggestions you can work with to increase the TIE ratio include:
- Increasing revenue to boost earnings before taxes and interest. It ensures that your financial statements read well so that lenders will not have a problem going through your numbers.
- Decrease expenses by streamlining operations
- Significantly reducing debts
- Reducing fraud instances
- Refinancing to lenders with lower interest rates
While a higher TIE ratio suggests that a firm is at a lower risk of meeting debt costs, it’s not necessarily a universally good thing. In some cases, a profitable company with a little debt and a high-interest coverage ratio may be forgoing crucial opportunities to leverage profitability in a way that creates shareholder value. It could imply that a firm is not utilizing excess income into re-investment opportunities through new projects or expansions. Instead, the company may be paying debts too quickly. As a result, long-term investors may lose favor with companies with high TIE ratios. For sustainable growth, businesses should reinvest in their operations.
Problems With the Times Interest Earned Ratio
While the interest coverage ratio helps measure solvency, it also comes with a few limitations, such as:
- TIE ratio uses earnings that a company gets before tax and interest. The figure does not reflect the cash that a company generates. TIE ratio number can be higher, but it does not indicate that a firm may not have money to pay its interest expenses.
- The ratio primarily focuses on a company’s short-term ability to cover the interest costs.
- The interest coverage ratio only considers interest expenses. The ratio does not account for principal payments, which may be huge and lead to a firm’s insolvency. Sadly, a company may have to refinance at unfavorable terms like higher interest rates or even file for bankruptcy. To analyze the solvency of a firm, other aspects like debt ratio and debt-equity must be considered.
- If most of a company’s sales run on credit, it may constantly get a low-interest coverage ratio even when receiving significant cash flow.
- The amount of interest you use for this calculation in the denominator is an accounting measurement. It may include a premium on the sale of bonds or a discount; hence not include the actual interest a firm needs to pay. To steer clear from such issues, it’s better to use interest rates on the face of the bonds.
Times Interest Earned Ratio Example
To further understand TIE ratios, check out the following times interest earned ratio example. Company DEA has an operating income of $200,000 before taxes. The total interest cost for the firm is $40,000 for the fiscal year. Here is how the company will calculate its TIE ratio number
- EBIT: 200,000
- Total interest Expenses 40,000
Solution: 200,000/ 40000=5
Times interest earned ratio is five times for company DEA.
Times interest earned ratio is one of the accounting ratios that stakeholders use to determine whether or not a company is in good standing to receive financing. Debtors are usually more inclined to offer debt to firms with higher interest coverage ratios. Business owners seeking finance should strive to manage operations better to have higher operating income. It is one of the ways to achieve a higher TIE ratio to become better candidates for lending companies.