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 calculates the number of times that a company could pay its periodic interest expenses should it devote all of its EBIT to debt repayments.
The TIE’s main purpose is to help quantify a company’s probability of default, which will in turn help 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 would mean that a company likely has a lower chance of defaulting on its loans, making it a safer investment opportunity for debt providers. Conversely, a low TIE would mean that a company has a higher chance of defaulting as it has less money available to dedicate to debt repayments.
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 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 the inclusion of 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 that has an excessively high TIE ratio could point to a lack of productive investment by the company’s management. A very high TIE would suggest 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. It 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 will 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’ debt to assets ratio increased five-fold from 2015 to 2018. It may be an indicator that Harry’s is managing its creditworthiness well, as it is continually able to increase its profitability by a greater amount while not taking on additional debt to fund its operations. If Harry’s needs to fund a major project to expand its business, it can viably consider to finance it with debt rather than equity.
To better understand the financial health of the business, the interest earned ratio should be computed for a number of companies that operate in the same industry and compared. If some 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 good job of managing its degree of financial leverage. In turn, creditors may be more likely to lend more money to Harry’s if the company represents a fairly safe investment within the bagel industry.
Thank you for reading this article! CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources: