What is Times Interest Earned Ratio
What is times interest earned ratio?
For a business owner, one of the questions to know the answer to is that what is times interest earned ratio? However, if you are not a business owner but a student of finance, this will enlighten you on the topic.
Times interest earned ratio is one of the common terms in accounting, it is also known as Interest coverage ratio. This ratio is a measure of the amount of income that can cover future interest expenses. These interest payments are categorized as fixed and ongoing expense since they are usually prolonged.
Simply, the times earned ratio is the measurement of a company’s ability to fulfill its debt obligations based on its income. This ratio can be calculated mathematically using a formula and this will be discussed in this article.
Like most ratios and measurements, there are high times interest earned ratio and low times earned interest ratio. The importance and the best for a company of these levels will also be discussed. This ratio can be used for the measurement of a company’s financial benchmarks and position.
It is also used as a measure of solvency, which measures the possibility of the company to fulfill possible debts. The main purpose of this ratio is to help in determining a company’s probability of missing out on payment. Hence, finding out how well the current income can sustain debt obligations will help in proper financial planning.
Also, for developing companies, knowing for how long the current income can handle possible debts will help in prioritizing growth. Whether to gain more assets, to source for other means of income, invest in opportunities, or maintain the trend.
How to calculate the times interest earned ratio?
As mentioned earlier, the TIE ratio is calculated using a formula, this is simple to learn or calculate. The calculation involves dividing the total earnings of the business before taxes and interest payment by the interest expense.
Mathematically, it is represented as:
TIE ratio = Earnings before interest & Taxes/Interest Expense
Where: Earnings before interest and taxes usually denoted as EBIT is the profit made by the business. This is without the Tax or interest payments factored in.
Interest Expense represents the payment to be made over the long-term. As explained earlier, the interest payment is treated as fixed and ongoing.
Now, this calculation will give a number that should not be represented in percentage. Rather if the TIE value obtained is 4, this means that the company can pay the debts 4 times over. This will remain true as long as the income is consistent. However, if the value obtained is 1, this means that the business has only enough income to manage its debts. In this case, a business rundown can be expected except if investments and financial supports are obtained.
Hence, as proven above, the TIE ratio provides a business with its financial state. For a business with a TIE ratio of 4, obtaining more assets that can increase productivity is a good move.
Therefore, having 4 as a TIE ratio can be termed as a good TIE ratio and the 1 ratio can be bad. In measuring the TIE ratio of a business or company, the higher the better.
Analyzing the TIE ratio of a company
Having a high TIE ratio is a sign that a company’s income is sufficient to handle its interest expense. However, having an excessively high value could mean low re-investment by the company, which could be toxic in the long-run. Therefore, not having enough re-investment by the company in researches and development can cause several challenges long-term.
Nevertheless, having a low ratio means the business has low profitability and needs development. To increase the total income, the company will have to focus on efficiency and also check their customer credits. Most companies with low credit are as a result of having an inefficient credit collection system resulting in low income.
To fund projects, it is preferred for a business to consider equity financing if the TIE ratio falls low. However, with a high and stable TIE ratio, considering debt financing will be much preferred. It is less risky and easier to get a loan for a business with a high TIE ratio than otherwise.
What is the one difference between the current ratio and the times interest earned ratio?
The current ratio and times interest earned ratio are synonymous and could be interchanged. However, there is a difference between these terms. The current ratio is also a measuring value to determine a firms’ liquidity; the possibility of converting the assets into cash. Similar to other ratios, there are the high-level and low-level and these determine if the ratio is good or bad.
There is one major difference between these two terms, the time frame. The current ratio is limited in that it measures a company or firm’s ability to meet its short-term obligation. While the times interest earned ratio measures its ability to fulfill long-term debts.
A current ratio compares the current asset and liability of a company. This occurs by dividing the current asset by the current liability. Obtaining a number of less than 1 shows inefficiency in the company’s productivity. However, a value between 1.2 and 2 is expected for a higher ratio. This shows that the company has assets that are double its liabilities.
However, it is important to compare the value of a compare with others of the same sector. A company having an excessively high value than its counterpart could be a sign of inefficient management.
The times interest earned ratio quantifies how well a company can handle its debt obligations without fail. It is a measure of the interest expenses of a company in terms of its income. A company with a low ratio is at credit risk and will find obtaining a loan difficult. However, for a company with a high and stable ratio, there is room for growth as financial institutions and creditors will be willing to provide loans.
It is important to know the TIE ratio of your company and be aware of the possible ways to improve earnings. What is the times interest ratio of your business? Find out and it might save you a lot.