What is times interest earned ratio ?
The times interest earned ratio is sometimes known as interest coverage ratio, may be a coverage ratio that measures the proportionate amount of income that can be utilized to cover interest expenses in the future.
It shows how many times the annual interest expenses are covered by the net operating income (income before interest and tax) of the company. It is a long-term solvency ratio that measures the power of an organization to pay its interest charges as they become due.
This ratio is known by various names such as debt service ratio, fixed charges cover ratio and Interest coverage ratio. The ratio is expressed in times.
It is an indicator of the company’s ability to pay off its interest expense with available earnings. It is a measure of a company’s solvency, i.e. its long-term financial strength.
It helps to evaluate how many times a firm’s operating income i.e. earnings before interest and taxes may settle the firm’s interest expense.
A higher TIE indicates that the company’s interest expense is low relative to its earnings before interest and taxes (EBIT) which indicates better long-term financial strength, and vice versa.
Advantage of Times Interest Earned Ratio
- This measures the proportionate amount of income.
- It is a long-term solvency ratio.
- It shows the capability of a firm to pay its interest charges as they become due.
- Indicates better long-term financial strength
Disadvantage of Times Interest Earned Ratio
- Many times TIER indicates the company’s interest expense is low with compare to its earnings before interest and taxes (EBIT)
TIER is formulated by dividing earnings before interest and tax (EBIT) for a period with interest expense for the period as follows:
Analysis and Interpretation Times Interest Earned Ratio:
TIER is very important from the creditors view point. A high ratio ensures a periodical interest income for lenders. The companies with weak ratio may have to face difficulties in raising funds for their operations.
Generally, a ratio of 2 or higher is considered adequate to protect the creditors’ interest in the firm. A ratio of less than 1 means the company is likely to have problems in paying interest on its borrowings.
A very high times interest ratio may be the result of the fact that the company is unnecessarily careful about its debts and is not taking full advantage of the debt facilities.
You are a Corporate Relationship Manager at ABC Bank. You recently received applications from two FMCG companies, A & B, for 5-year financing.
Your segment head has asked you to do some preliminary ratio analysis to assess whether the companies’ financial strength is good enough to warrant detailed cash flows based analysis.
Following are excerpts from their balance sheets and income statements:
|Company A||Company B|
|Total liabilities||15 million||30 million|
|Total assets||30 million||40 million|
|Earnings before interest and taxes (EBIT)||2.5 million||2 million|
|Interest expense||1 million||1.5 million|
We can assess the solvency of the companies by calculating and comparing debt ratio and times interest earned ratio for both the companies, which are as follows:
Debt ratio of Company A = 15 million/30 million = 0.50
Debt ratio of Company B = 30 million/40 million = 0.75
Times interest earned ratio of Company A = 2.5 million/1 million = 2.5
Times interest earned ratio of Company B = 2 million/1.5 million = 1.33
The ratios indicate that Company A has better financial position than Company B, because currently 50% of its total assets are financed by debt (as compared to 75% in case of Company B).
Further, Company A is better at paying off its interest expense as indicated by its times interest earned ratio of 2.5 (as compared to 1.33 in case of Company B), which means that the Company A can bear an interest expense 2.5 times its current interest expense while Company B can barely pay off its current interest expense.