Times interest earned (TIE) is a financial ratio that measures a company’s ability to meet its interest obligations based on its current income. This ratio is important to current and prospective creditors of the company as well as to investors and financial analysts because it shows how many times the company’s pre-tax income will cover their interest costs that arise from various types of debt, like bank loans, bonds outstanding, and others. (This ratio is sometimes also referred to as the interest coverage ratio.)
The times interest earned ratio is an indicator not only of a company’s ability to cover its debt obligations, but an indicator of the company’s overall financial strength. A company that is barely able to service its debt might be more susceptible to an economic downturn than one that is able to cover its debt obligations many times over.
Debt has to be paid and is a true obligation of any company. If a company is struggling to service its debt, it will not have funds for reinvesting in the business to fuel growth. Companies that default on their debt obligations may end up going through bankruptcy or even ceasing to be in business.
The TIE ratio is important for all companies, but especially for those companies with a capital structure comprised of a high percentage of debt financing as opposed to equity. This might be common among firms in capital intensive industries such as utilities and many types of manufacturing.
What does times interest earned tell us?
Times interest earned is a measure of a company’s financial solvency—whether a company has sufficient assets to meet its liabilities. Business cash inflows can fluctuate, but their bills tend to be more constant and have to be paid, including interest on debt.
A times interest earned ratio of less than one times would indicate that the company does not generate enough in operating earnings to service the interest payments on the company’s debt.
While a higher times interest earned ratio is generally considered to be a good thing, it might also indicate that the company is underutilizing debt as a part of its capital structure. While this will reduce its interest costs, the lack of financial leverage on its balance sheet could rescue the company’s profitability over time.
How to calculate times interest earned
In calculating the times interest earned ratio, there are several variables to consider.
Earnings before interest and taxes (EBIT), which is the company’s net earnings with interest expenses and taxes added back. This number tells you what the company generates from its operations, in other words from its core business operations versus the impact of any accounting “magic.”
Total interest costs on all debt, including any loans from banks or other lenders and interest payments on debt instruments, such as bonds.
The calculation is very straightforward, you take earnings before interest and taxes and divide this number by the company’s total interest payments.
For example, if a company’s EBIT is $90 million and its total interest payments on its debts amount to $30 million, then $90 million divided by $30 million would give us a times interest earned ratio of 3 times. In other words, the company’s operating earnings cover their interest payments by a factor of 3 times.
In order to truly understand if a times interest earned ratio of 3 times is good you would need to look at some comparisons. For example, has the trend in this ratio remained consistent, or has it improved or trended worse over the past several years? Analysts will often look for trends in the various financial ratios they measure for a company to see how the company’s financial position
Another basis of comparison is to look at this ratio in comparison to other companies in the firm’s same industry. Is their times interest earned ratio similar, better or worse? Is the difference significant?
A higher times interest ratio could indicate several things, including:
The company’s operations are more profitable than its competitors, which would typically result in a better earnings
A company that uses debt as a lower percentage of its capital structure will generally have a higher times interest earned ratio, all else being equal. The opposite is true as well. A company that employs a greater percentage of debt in its capital structure will likely have a less favorable times interest earned ratio than its peers due to the higher interest costs that it probably incurs as a result.
How to improve the times interest earned ratio
For companies looking to improve this ratio, there are a number of steps to consider.
Pay down debt
Reducing the amount of debt on the company’s balance sheet will serve to lower the company’s interest payments. Depending upon the terms of the debt and the type of debt, the company may be able to retire some of it, this will generally reduce the company’s interest payments making the ratio more favorable all else being equal.
Use greater levels of equity in the company’s capital structure
In order to properly capitalize the business, companies will need to either issue debt or use equity as a source of capital. For most companies this portion of their balance sheet is a combination of the two. Reducing the proportion of debt to equity will generally reduce the company’s level of interest payments.
In fact, one way to pay down their debt would be to offer more equity to investors in the form of stock.
Increase earnings
This may be easier said than done but increasing the company’s earnings will improve this ratio. The company profitably increasing its sales will help increase earnings before interest and taxes. This in turn will help improve the times interest earned ratio.
Decreasing expenses is, of course, another way to increase earnings. Lowering expenses can add to the company’s bottom line as well.
Times interest earned can be a useful financial ratio, especially if analyzed in conjunction with a series of other financial metrics in analyzing the financial health of a company.
