The times interest earned ratio (TIE) is one of several figures that you can use to determine a company’s debt ratio or your business’s solvency. So that’s a handy number to know, right? In this post, we’ll explain what kind of information TIE can communicate to you and show a simple formula for calculating it. Let’s get started!
What is Times Interest Earned?
Times interest earned ratio communicates your business’s ability to make interest payments on its current debt. It can tell you if you can pay the due interest and other expenses on your debt now and whether you’ll be able to do so in the future.
Sometimes, times interest earned is also referred to as “fixed charge coverage”. Essentially, this number tells you the amount of income available to make interest payments in the future.
The Pros and Cons of Calculating Time Interest Earned Ratio
Like any other number that is used to determine a company’s current and future viability, TIE calculation has some limitations. So let’s take a closer look at these, along with the advantages of using this ratio.
Pros of Using TIE
- This is an easy number to calculate
- The ration is handy to compare the solvency of two companies as an investor
- Provides insight into the solvency of your own business
- A negative ratio is a quick way to determine that your company is facing financial difficulties.
Cons of Using TIE
The times interest earned calculation is largely based on Earnings Before Interest and Taxes (EBIT) figure that may not be entirely reliable.
The EBIT numbers are not always an accurate reflection of the cash your business generates. For example, if sales are made largely on credit, that can muddy things up. Same goes for companies with long billing cycles and lofty payment terms.
Basically, any upcoming payment on the principal will not be reflected in this figure. What this means is that the TIE may seem favorable, but your business could have a principal payment coming due hat might eliminate a big chunk of your EBIT.
It generally reflects your solvency in the short term, unless there is unlikely to be any future changes in your earnings and expenses.
This makes the interest expense figure misleading. It, too, is the result of a calculation that may not accurately reflect your actual interest expenses. That’s why you should triple-check your numbers when doing this calculation!
How to Calculate Times Interest Earned Ratio
As mentioned already, the times interest earned ratio formula is pretty simple to figure out:
Times Interest Earned Ratio (TIE) = Income Before Interest and Taxes (EBIT)/Interest Expense
Of course, the best way to understand the results of this calculation is to look at a real-world example.
Sample TIA Calculation
Tina’s Camping Supply and Outfitters sells camping other outdoor gear to hikers, campers, and other nature lovers. Tina wants to obtain a loan to expand her current store into the vacant space next door. Of course, her bank asks for her financials before they give her an answer. Here are her numbers.
- EBIT = $200,000
- Interest Expense For Year = $20,000
Here’s her calculation:
TIE = $200,000 / $20,000
That makes her times interest earned ratio equal 10.
What this means is that Tina’s Camping Supply and Outfitters has an income that is ten times more than its annual interest expenses. Unless some disaster strikes, Tina can afford to make the payments on a new loan.
Now, what if Tina was paying significantly more in interest. Imagine that she had credit issues, and previously could only secure a loan at a very high rate of interest with tough repayment terms. Let’s say her annual interest expense was $50,000. Here’s that revised calculation:
TIE = $200,000 / $50,000
Now the TIE is four. That’s a much lower ratio. However, even this figure makes Tina a pretty good candidate.
What is a Good Times Interest Earned Ratio?
Even with a ratio of four, Tina is still a good credit risk for a bank. In general, a ratio of 2.5 or higher is considered to be an acceptable risk for lenders.
It’s also very important to realize that a high ratio isn’t always a good thing. Imagine a company that has a much higher TIE than other businesses in the same industry. That could be a red flag. It may show that the company isn’t making smart choices in terms of debt repayment, or that they aren’t reinvesting earnings into growth and development. Keep in mind that fast repayment of debt isn’t always a wise choice.
Figures like times interest earned ratio help you to better understand your debt and income. This number also reflects how lenders will see your business should you need to borrow money. So keep an eye on this number as part of your overall cash flow management practices!
Photo by Oleg Magni