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.