What is the Times Interest Earned Ratio?
The Times Interest Earned (TIE) ratio measures a company’s ability to meet its debt obligations on a periodic basis. This ratio can be calculated by dividing a company’s EBIT by its periodic interest expense. The ratio shows the number of times that a company could, theoretically, pay its periodic interest expenses should it devote all of its EBIT to debt repayment.
The TIE’s main purpose is to help quantify a company’s probability of default. This, in turn, helps determine relevant debt parameters such as the appropriate interest rate to be charged or the amount of debt that a company can safely take on.
A high TIE means that a company likely has a lower probability of defaulting on its loans, making it a safer investment opportunity for debt providers. Conversely, a low TIE indicates that a company has a higher chance of defaulting, as it has less money available to dedicate to debt repayment.
How to Calculate the Times Interest Earned Ratio
The Times Interest Earned ratio can be calculated by dividing a company’s earnings before interest and taxes (EBIT) by its periodic interest expense. The formula to calculate the ratio is:
Earnings Before Interest & Taxes (EBIT) – represents profit that the business has realized, without factoring in interest or tax payments
Interest Expense – represents the periodic debt payments that a company is legally obligated to make to its creditors
Generally speaking, the higher the TIE ratio, the better. However, a company with an excessively high TIE ratio could indicate a lack of productive investment by the company’s management. An excessively high TIE suggests that the company may be keeping all of its earnings without re-investing in business development through research and development or through pursuing positive NPV projects. This may cause the company to face a lack of profitability and challenges related to sustained growth in the long term.
Times Interest Earned Ratio Example
Harry’s Bagels wants to calculate its times interest earned ratio in order to get a better idea of its debt repayment ability. Below are snippets from the business’ income statements:
The red boxes highlight the important information that we need to calculate TIE, namely EBIT and Interest Expense. Using the formula provided above, we arrive at the following figures:
Here, we can see that Harrys’ TIE ratio increased five-fold from 2015 to 2018. This indicates that Harry’s is managing its creditworthiness well, as it is continually able to increase its profitability without taking on additional debt. If Harry’s needs to fund a major project to expand its business, it can viably consider financing it with debt rather than equity.
To better understand the financial health of the business, the ratio should be computed for a number of companies that operate in the same industry. If other firms operating in this industry see TIE multiples that are, on average, lower than Harry’s, we can conclude that Harry’s is doing a relatively better job of managing its degree of financial leverage. In turn, creditors are more likely to lend more money to Harry’s, as the company represents a comparably safe investment within the bagel industry.
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