The times interest earned ratio is computed as a measure of a company’s ability to meet its interest payments with its earnings before interest and taxes (EBIT). This ratio is used by investors and analysts to assess the financial health of a company and its ability to cover its debt obligations. The calculation involves the company’s net income, interest expense, taxes, and depreciation and amortization.
Calculating the Times Interest Earned Ratio
The times interest earned ratio (TIE ratio) is a measure of a company’s ability to meet its interest payments on its debt. It is calculated as follows:
TIE ratio = Net income + Interest expense / Interest expense
Components of the TIE Ratio
- Net income: This is the company’s profit after all expenses, including interest expense, have been paid.
- Interest expense: This is the amount of interest that the company pays on its debt.
Interpretation of the TIE Ratio
A higher TIE ratio indicates that a company is more able to meet its interest payments. A lower TIE ratio indicates that a company is less able to meet its interest payments.
Generally accepted TIE ratio ranges by industry:
| Industry | TIE Ratio Range |
|---|---|
| Utilities | 2.5-4.0 |
| Manufacturing | 2.0-3.5 |
| Retail | 1.5-2.5 |
| Services | 1.0-2.0 |
Factors that Affect the TIE Ratio
The TIE ratio can be affected by a number of factors, including:
- The level of interest rates: Higher interest rates will result in a lower TIE ratio.
- The amount of debt that a company has: A company with more debt will have a lower TIE ratio.
- The profitability of a company: A more profitable company will have a higher TIE ratio.
Example
Suppose that a company has net income of $1 million and interest expense of $200,000. The company’s TIE ratio would be:
TIE ratio = $1 million + $200,000 / $200,000 = 6x
This indicates that the company is able to meet its interest payments 6 times over.
Question 1:
How is the times interest earned ratio computed?
Answer:
The times interest earned ratio (TIER) is calculated by dividing earnings before interest and taxes (EBIT) by interest expense.
Question 2:
What does the times interest earned ratio measure?
Answer:
TIER measures a company’s ability to cover its interest payments from its earnings.
Question 3:
Why is the times interest earned ratio important?
Answer:
TIER is important because it helps investors and creditors assess a company’s financial leverage and solvency.
Alrighty folks, that’s the skinny on the times interest earned ratio. Hope it’s given you some food for thought. Feel free to hit me up if you have more financial questions, or if you just want to chat. And remember, knowledge is power, so keep on learning and growing. Thanks for hanging out with me today, and catch you on the flip side!