Times interest earned is a way of measuring a company's ability to pay off the interest accruing on its loans. It is expressed as a ratio that is calculated by taking the company's earnings prior to interest and taxes and dividing it by the amount of interest owed. Also known as the interest coverage ratio, times interest earned, or TIE, provides a method for investors to measure a company's financial stability. An extremely low ratio means that a company may not be able to take care of its interest payments in the short term while still having capital in reserve for day-to-day operations or emergency expenses.
Interest payments are a fact of life for most businesses, as borrowing money is often necessary at various stages of a company's development. The inability to pay off the interest incurred on any loans is a sign of weakness and could be a harbinger of eventual insolvency for a business. Times interest earned is a ratio designed to show how many times a company can pay off its interest, which can be a good indicator of its short-term financial soundness.
To calculate the times interest earned for a particular company, the earnings before interest and taxes, or EBIT, must be totaled. That number is then divided by the company's total payable interest on all debt. Both of the numbers to be divided must come from the same predetermined time period for the calculation to be accurate.
For example, a company amasses earnings over a specific time period of $5,000 US Dollars (USD), a total that represents the amount they have earned before taxes and interest are taken out. Over the same time period the interest owed by that company is $2,000 USD. Dividing the $5,000 USD by $2,000 USD results in a times interest earned ratio of 2.5. This essentially means the company can pay off its interest obligations 2.5 times before running out of capital.
While a low ratio could be problematic if it gets down near the base level of 1.0, there is no absolute benchmark number for an acceptable TIE. Businesses in more volatile industries may require a high ratio to deal with potential ups and downs, while companies in steadier industries may be able to get away with a lower score. It's also not necessarily a good thing if a company has an excessively high times interest earned. This may mean that the company has spent too much of its capital paying down its debt rather than making other more worthwhile investments to grow the company.
allenJo Post 4 |
@SkyWhisperer - I think EBITDA is the EBIT plus depreciation and amortization, neither of which is mentioned in the basic times interest earned calculation.
The reason that they are not mentioned is that depreciation and amortization are only important if you are dealing with significant asset exposure, which are subject to depreciation and amortization. These don’t make up the simple profit formula however. In some businesses, like telecommunications, you would definitely want to look at the EBITDA number because telecommunication is capital intensive. |
SkyWhisperer Post 3 |
@David09 - Does anyone know what the difference is between EBIT and EBITDA? I ask because I notice that investors and analysts like to talk about a company’s EBITDA. I assume that it’s very important and that it must be an extension of the basic EBIT concept. |
David09 Post 2 |
@nony - I notice that the interest formula is unique in that the higher the number, the safer the investment is considered. A low interest formula ratio means that the debt is pretty high relative to earnings.
This formula in that sense is different than other barometers of a company’s overall health. For example, take the price to earnings ratio. Generally the lower the PE ratio the healthier the company is. It means that it won’t take that company long to earn back the prices paid on its shares at current market levels.
I know this is obvious but it’s something you should remind yourself of when looking at the interest formula ratio so you don’t automatically assume the lower number is a good thing, and make the wrong investment in the process. |
nony Post 1 |
I worked in the telecommunications industry and of course in that industry you spend billions of dollars for infrastructure just to get up and running.
Most of that money was financed by loans. Investors were always scouring our quarterly reports to see how we were doing with cash flow and of course the financial ratio between earnings and debt; specifically, investors wanted to know if we were making any money and how were we doing on our interest payments.
Well for the longest while we were doing okay. We kept assuring everyone that we were able to meet the interest on our debt, although that interest consumed more and more of our resources as our real earnings dwindled. Eventually we couldn’t even pay the interest anymore and had to file for bankruptcy. |