What is the Times Interest Earned Ratio?
The times interest earned ratio, or the interest coverage ratio is a metric that represents how much proportionate earnings can be spent by a company to pay for its future interest costs.
In many ways, the times interest earned ratio can also be used as a solvency ratio. The reason behind that is the fact that it can be used to calculate a company’s ability to pay for interest and debt services. Since these interest payments are made over the long term, they are classified under the continuing, fixed cost category. Similar to most fixed expenses, a failure to pay for these costs can lead to a firm’s bankruptcy. Because of that, the times interest earned ratio is used as a solvency ratio. Let’s find out more about it.
Times Interest Earned Ratio: All You Need to Know
What is the formula for the Times Interest Earned Ratio?
This is the Times Interest Earned Ratio formula:
Times Interest Earned = (EBIT)/(Interest Expense)
The EBIT (earnings before interest and taxes) and interest expense are both included in a company’s income statement. The interest expense and income taxes are usually reported together to help with simplifying solvency analysis. These are kept separate from normal operating expenses at all times. This also makes it easier to calculate EBIT.
The times interest earned ratio is usually expressed as a number and not a percentage value. The ratio shows how many times a business could pay its interest costs using its pre-tax earnings. This indicates that the bigger the ratio, the better the company’s financial position is. For example, a ratio of 3 means that a company has enough money to pay its total interest cost, even if this was multiplied by 3.
A higher times interest earned ratio encourages creditors to lend money to a company. This is because it proves that the company is capable of paying its interest payments when due. Therefore a higher times interest earned ratio signifies that the company is safer to invest in, and vice versa.
A financial analyst can create a time series of the times interest earned ratio to have a clearer grasp of the business’ financial status. A single ratio may not mean anything because it could only speak for one set of revenues and earnings. By calculating the ratio on a regular basis, this value will become more meaningful in terms of representing a company’s true fiscal status.
Times Interest Earned Ratio: Example
Let’s say a fiem has has $5 million in 2% debt outstanding and $5 million in common stock. The firm has to generate more money before it can afford to buy equipment. The cost of capital for incurring more debt has an annual interest rate of 3%. Investors are looking forward to annual dividend payments of 4% plus an increase in the company’s stock price. The company issues further debt of $5 million. Therefore, its total annual interest expense will be $500,000 and its EBIT will be $1.5 million.
Let’s break it down to identify the meaning and value of the different variables in this problem.
- EBIT: 1,500,000
- Interest Expense: 500,000
We can apply the values to our variables and calculate the times interest earned ratio:
Times Interest Earned Ratio = (1,500,000)/(500,000) = 3
So the firm’s times interest earned ratio of the firm in question is 3. This means the company is generating enough income to cover its total interest costs 3 times over. Simply put, its income is 3 times greater than its interest expense for the year.
How does Times Interest Earned ratio help analyze companies?
Many factors can have an influence on the times interest earned ratio. One of them is the company’s decision to either incur debt or issue stock for capitalization purposes. Businesses make choices by looking at the cost of capital for debt or stock.
Generally speaking, a company that makes a consistent annual income can maintain more debt as part of its total capitalization. When a creditor finds that a business has consistently made enough money over a period of time, the company will be viewed as a better credit risk.
Utility firms, for instance, are regularly making an income since their product is a necessary expense for consumers. In some cases, up to 60% or even more of a these companies’ capital is funded by debt.
On the other hand, startups and other businesses that don’t have regular incomes usually issue stocks for capitalization. As soon as a company can show a track record of making stable earnings, it can start funding its capital via debt offerings too.
What are the limitations of the Times Interest Earned Ratio?
Despite its uses, the times interest earned ratio also has its limitations, such as the EBIT not providing an accurate picture as this value does not always reflect the cash generated by the company. For instance, sometimes, sales are made on credit, and it’s possible for a company’s ratio to come out low in the calculation despite excellent cash flows.
Also, Interest Expense is an accounting calculation that is not always exactly correct, as when it includes premiums or discounts on bond sales, for example, instead of the given rate on the face of the bonds.
Neither does the metric consider any forthcoming principal payments, and the calculation can yield a favorable number despite the company’s principal payment being so large that it can gobble up the entire EBIT. Lastly, since the ratio based on current earnings and expenses, it can only reflect the company’s ability to pay interest in the short term.
As a solution, EBITDA (earnings before interest, taxes, depreciation, and amortization) should be used instead. Being non-cash expenses, depreciation and amortization will not affect the company’s cash position in any way.
Times Interest Earned Ratio: Conclusion
SO by now you must have got a clearer picture of what times interest earned ratio is. It measures a company’s ability to pay its interest expenses. Calculating the times interest earned ratio depends on two variables: earnings before interest and taxes (EBIT) and interest expense. The times interest earned ratio is also usually expressed as a number instead of a percentage. A higher times interest earned ratio signifies towards a firm having more cash to cover its debts and have more money to invest in business. The limitations of the times interest earned ratio can be overcome with the help of the EBITDA.