Times interest earned ratio (TIE), which is also known as interest coverage ratio, measures the ability of a company to meet interest expense on its debts outstanding using its available earnings. TIE ratio refers to the group of solvency ratios because that interest expense usually emerges on a long-term basis (e.g., coupon payments on bonds outstanding), so it can be treated as fixed expenses. Thus, times interest earned ratio measures the solvency of a company in the long run.
The formula of times interest earned ratio is expressed as follows:
where EBIT is earnings before interest and taxes (also known as operating income).
The reason to use EBIT in a formula is that interest expense is tax deductible, i.e., a company carries interest expense before paying income tax.
The alternative approach recommends using EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) instead of EBIT because depreciation and amortization are noncash expense; thus, a company can use that cash to pay interest.
The reported statement of income of the XYZ Company is as follows:
The depreciation and amortization expense is $5,370,000.
The TIE ratio of the XYZ Company is 2.534.
Trend analysis of times interest earned ratio also gives an important clue. Let’s suppose that in the previous year it was 1.988. Its current value of 2.534 compared with a baseline of 1.988 indicates that the efforts of the company’s management improved its solvency in the long run.
Times interest earned ratio analysis
A higher interest earned ratio is favorable because it indicates that a company has enough earnings to pay its interest expense. Thus, this ratio is an important metric for creditors of a company. A lower number shows that a company has insufficient earnings to meet its debt obligations in the long run.
The actual value of TIE ratio should also be compared with that of other companies working in the same industry. Let’s consider the example above and assume the industry average in the current year is 3.425.
The current year value of 2.534 compared with the industry average of 3.425 indicates that management’s efforts are insufficient to improve the solvency of the company and reduce credit risk.
You can also calculate the times interest earned ratio using our online calculator.