Times interest earned ratio allows looking at how much money the company is bringing in and evaluate if it can take care of its immediate financial burdens. One of these burdens is the interest companies have to pay to be able to use the money they have taken from financial organizations, such as banks.
The number you arrive at when calculating this ratio will show you and other parties how many times you would be able to cover the amount you owe for using the money borrowed. For instance, if you get 5.5, it means that you are not only able to pay the interest expense for that period, but you can do it more than 5 times.
Data needed to calculate this ratio is collected from the Income statement. You can see the calculation formula above. If you subtract all operating expenses from revenue, you will get the EBIT value. This is the amount available to pay interest on funds loaned as well as pay the government the taxes owed, and whatever will be left after the payments goes to the shareholders as net income.
As you might have guessed, everyone is looking for a number that is If the ratio equals or goes below 1.5, doubts about the company’s ability to cover its interest payments might occur. If the value of the TIE ratio is below 1, it means that the company is unable to cover its interest payments because it earns less money than the amount it has to pay as interest.
If a business went bankrupt, you would usually see a low interest coverage ratio on their financial reports. A recent example is The Hertz company that filed for U.S. bankruptcy in 2020. If you look at their financial statements, you can see that it already had trouble making its interest payments back in 2018. Although things got a little better in 2019, the company experienced a loss in 2019 largely due to a sharp decrease in car rentals and was not able to pay its interest.
Nuts & Bolts Co. has an interest of $35,000, an EBITDA of $128,500, and a depreciation and amortization expense of $32,000. To calculate the TIE ratio, we first need to find how much money the company made before paying the interest and taxes by subtracting depreciation and amortization from the EBITDA value. EBIT would equal to $128,500 less $32,000 or $96,500.
Now, we just need to divide $96,500 by $35,000 to get a ratio of 2.76. We can tell that this company can make interest payments and will still have money left over for other business needs. However, keep in mind that this ratio is more useful when it is used for comparison than by itself.
This financial ratio for evaluating the long-term debt of a business can also be analyzed over time. Generally, it would be desirable to see a ratio that is increasing or remaining stable over time. For example, if for the past few years the indicator was higher, the investors might see a decreasing trend, showing difficulty paying its interest expense. This in turn can mean that a company will not be able to acquire a new loan.