A company’s ability to pay its debts on the amount of income it’s earning is expressed as the times interest earned, or “TIE,” ratio. It’s also sometimes referred to as an interest coverage ratio or debt service ratio. It’s a solvency ratio that can dictate a company’s ability to borrow and whether it’s in danger of folding and closing its doors, according to Saylor Academy.
The TIE ratio is a periodic measurement. It’s subject to change as time unfolds. Some minor calculation is necessary to arrive at it for a given time period.
The Times Interest Earned Ratio Formula
The TIE metric is a matter of basic math. You must simply divide the company’s earnings before interest and taxes (referred to as a company’s EBIT) by the total interest it owes on its debts per accounting period. Bond interest owed by the company should be included here as well. Its TIE ratio would be 2.0 if its EBIT is $2 million a year and its annual interest expense is $1 million. It’s double what the company owes in interest each year.
The required information can typically be found on a business’s income statement and other financial statements. The EBIT factor may be displayed as a company’s income before interest and taxes, or IBIT. Look for the company’s net income and then add the amount of interest and taxes back in.
What Does the TIE Ratio Mean?
The TIE ratio is a clear snapshot of a company’s ability to meet interest payments on its debt obligations as they come due. A company’s TIE ratio tells lenders the likelihood that the company will default if it should make loans to the business. A low TIE means it’s already carrying a high amount of debt, so it could well be a credit risk.
A TIE of 2.0 or higher tells banks and institutions that the company is likely to be able to pay off both its short-term and long-term debt. This can directly affect the interest rates a company is charged and how much it’s able to borrow.
A low TIE is considered to be less than 1.0. It limits how much additional debt a company can comfortably take on and increases the interest rate it will pay. A company with a low TIE ratio would be more likely to resort to incurring new debt to fund various needs rather than using its equity. In fact, a company with a very low TIE ratio may not even be able to adequately fund its operations.
The National Association of Credit Management indicates that the average TIE ratio is about 1.5.
A Disadvantage of a High TIE
Of course, nothing about financial ratios is ever quite that black and white. A company with a very high TIE ratio might be just as suspect as one with a TIE ratio under 1. A higher ratio can indicate that the business is operating too cautiously and sitting on its cash flow and earnings rather than reinvesting operating income back into business operations and dedicating it to operating expenses. This can cause problems in the long term.
What the TIE Means to Investors
Investors can look for a TIE ratio that’s higher than another company’s ratio when they’re trying to decide in which to invest. This number tells them that the business can meet its debt payments while continuing to fund operations and invest in itself.
Just be sure that you’re comparing businesses in the same industry. You want to know whether a company in which you’re considering investing is outperforming its competitors. The TIE ratio won’t necessarily be indicative if you’re comparing an IT corporation to a doughnut maker.
This article was written by PocketSense staff. If you have any questions, please reach out to us on our contact us page.