Also called the interest coverage ration sometimes, the times interest earned ratio is a coverage ratio. It can calculate the proportionate amount of earnings that can be used in the future, in order to cover expenses for interest.
However, sometimes it’s considered a solvency ratio too, and that’s because it can estimate how able a company is to make interest and debt service payments. Interest payments are treated as a fixed expense that’s ongoing, considering they are, most of the times, made for the long-term.
Just like with most fixed expenses, if a firm is not able to make payments, it could lead to bankruptcy and, thus, to the company’s end. Therefore, this is why it could also be considered a solvency ratio.
If you’d like to understand it better, this article will help you in that aspect.
Analyzing Times Interest Earned Ratio
Opposed to a percentage, this ratio is stated in numbers. Its aim is to show how many times a firm is able to pay the interest with it before-tax income. So, as you can imagine, a higher ratio is preferred over a low one.
So, if a ratio is, for example, 5, that means that the firm has enough earnings to pay for its total expense 5 times over. In other words, the company generates income 4 times higher than its interest expense for the year.
As obvious, a creditor would rather prefer a company with a high times interest ratio. Such a ratio can indicate the fact that the firm is able to afford the interest payments by the due date. Moreover, a higher ratio doesn’t have as many risks as a low one does, as the latter one brings credit risks.
How Is It Calculated?
The calculation is not so difficult. Basically, you have to divide the income before interest and income taxes by the interest expense. The formula looks like this:
You can find both of these figures on the company’s income statement. Usually, you will find the interest expense and income taxes reported separately from the normal operating expenses for solvency analysis purposes. As a result, it will be easier to find the earnings before you find the EBIT or interest and taxes.
To understand this better, imagine that you have a company if you don’t already. Your firm wants to apply for a new loan in order to purchase equipment. You are asked for your financial statements before being granted the loan. So, you check your statement and you see that you made $400,000 of income before interest expense and income taxes. Overall, your interest expense for the year was $40,000. By using the formula, it results that your firm’s income is 10 times bigger than the annual interest expense.
Therefore, you can pay additional interest expenses, so the bank should accept offering you a loan.
If you didn’t know what a times interest earned ratio is, you hopefully understand it now. These paragraphs contain information that could be helpful for you in the future.