What is Times Interest Earned Ratio?
How to calculate times interest earned ratio?
What are the essential elements you should know!
In this article, we will break down the notion of Times Interest Earned Ratio so you know all there is to know about it!
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What Is The Times Interest Earned Ratio
The “times interest earned ratio” or “TIE ratio” is a financial ratio used to assess a company’s ability to satisfy its debt with its current income.
In other words, the time interest earned ratio allows investors and company managers to measure the extent to which the company’s current income is sufficient to pay for its debt obligations.
The interest earned ratio may sometimes be called the interest coverage ratio as well.
The times interest earned ratio interpretation can be as follows:
- Allows a company to measure how many times a company can make interest payments on its debt
- Allows a company to measure the probability of a company defaulting on its debt obligations
- Allows a company to measure how much more debt you can take on based on current earnings
A company must regularly evaluate its ability to meet its debt obligations to ensure that it has enough cash to not only meet its debt but also operate its business.
The higher the times interest ratio, the better a company is able to meet its financial debt obligations.
Times Interest Earned Ratio Definition
According to the Corporate Finance Institute, the times interest earned ratio is defined as follows:
The Times Interest Earned (TIE) ratio measures a company’s ability to meet its debt obligations on a periodic basis.
This is a great and simple way of defining the time interest earned ratio.
In a nutshell, it’s a measure of a company’s ability to meet its “debt obligations” on a “periodic basis”.
Why Calculate TIE Ratio
A well-managed company is one able to assess its current financial position (solvency) and determine how to finance its future business operations and achieve its strategic business goals.
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.
When a company has a high time interest ratio, it means that it has enough cash or income to pay its debt.
However, a company noticing that it has a ratio below one must carefully assess it’s business operations and priorities as it does not generate enough earnings to pay every dollar of interest and debt.
Companies with consistent earnings can carry a higher level of debt as opposed to companies with more inconsistent earnings.
This means that banks will expect a lower TIE ratio for companies with a proven history of consistent earnings (like utility companies, banks, or other) as opposed to companies who do not have stable earnings (like startups, businesses in high-risk industries etc).
Times Interest Earned Ratio Formula
The time interest earned ratio formula consists of the following:
TIE = EBIT / TIP
EBIT = Earnings Before Interest and Taxes
TIP = Total Interest Payable (or Interest Expenses)
As you can see from this times-interest-earned ratio formula, the times interest earned ratio is computed by dividing the earnings before interest and taxes by the total interest payable.
To calculate TIE, you first need to calculate the EBIT and then your Total Interest Expenses.
EBIT can be found in a company’s income statement representing its earnings before interest and taxes.
It reflects a company’s total earnings for a specific accounting period without consideration of its interest and tax obligations.
Total Interest Payable is all debt payments a company is required to make to creditors during the same accounting period.
This can be interest on loans, bonds, or other debt obligations.
How To Calculate The Times Interest Earned Ratio
Calculating the “time interest earned ratio” is done by using the “times interest earned ratio formula” as follows:
Time Interest Earned = Earnings Before Interest And Taxes / Total Interest Payable
Let’s take the following example to calculate TIE:
- Company’s total outstanding debt: $10,000,000
- Company’s interest obligations on outstanding debt: 5%
- Company’s earnings before interest and taxes: $5,000,000
TIE = ($5,000,000) / ($1,000,000 X 5%)
TIE = 10
In this example, the company has a high times interest ratio meaning that it has $10 of earnings to cover every dollar of debt.
This company should take excess earnings and invest them in the business to generate more profit.
Example of Times Interest Earned Ratio
Let’s look at an example to better illustrate the interest earned time ratio.
Let’s consider the following parameters for a company:
- Net income: $1,000,000
- Income taxes: $100,000
- Interest expenses: $200,000
In this example, the company’s time-interest-ratio can be calculated as follows:
TIE = ($1,000,000 + $100,000 + $200,000) / $200,000
TIE = 6.5
To calculate the EBIT, we took the company’s net income and added back interest expenses and taxes.
Then, we divided the EBIT by the company’s interest expenses.
In this example, the company can meet its debt obligations 6.5 times over.
Times Earned Interest Ratio Takeaways
So what is the financial definition of Times Interest Earned Ratio?
What is a good times interest earned ratio?
Is a high times interest earned ratio good?
Let’s look at a summary of our findings.
Times Interest Earned Ratio (TIE Ratio)
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