Times Interest Earned Ratio

When it comes to investing, one of the most important things to consider in terms of a company is its financial health. You cannot make a fully conscious decision about whether you should invest your hard-earned money in a business if you don’t know if it will be profitable.

That’s when the TIE ratio or Times Interest Earned ratio comes into play. What is it exactly and why is it one of the most important financial metrics? Keep on reading to find out.

What Is TIE Ratio? 

Times Interest Earned (TIE), also sometimes called an Interest Coverage ratio is a financial ratio used to evaluate a company’s ability to meet its debt obligations. Specifically, it measures the extent to which a company’s operating income can cover its interest expenses on outstanding debts.

How to Calculate Times Interest Earned Ratio

The TIE ratio is calculated by dividing a company’s earnings before interest and income taxes (EBIT) by its total interest expense. The resulting ratio indicates the number of times a company’s earnings can cover its interest payments.

So, following this logic we can deduce that the Times Interest Earned ratio formula is:

TIE ratio = EBIT (earnings before interest and taxes) / Interest expense

How does it look in reality?

Example

Let’s say a company has an EBIT of $100,000 and a total annual interest expense of $20,000. Using the TIE ratio formula, we can calculate the TIE ratio as follows:

TIE ratio = $100,000 / $20,000 = 5

This means that the company’s earnings are five times higher than its interest expenses. In other words, the company has enough operating income to cover its interest payments five times over.

It’s important to remember that, generally, when an investor is considering investing in a company, they will look at a broader period of time than just one year to decide whether it will be a profitable investment.

Example 

Let’s say that there are two companies – A and B. Mr. Smith is considering investing in one of them but isn’t sure which to go with. He looks at their TIE – company A has a TIE ratio of 15, while company B has a TIE ratio of 12. You would think that company A is a clear winner here, wouldn’t you?

Well, Mr. Smith decided to look at their TIE ratio within the last few years. What he found was that 5 years ago, company A had a TIE ratio of 35, and it has been gradually declining over the last couple of years. Company B, on the other hand, started with a TIE ratio of 2 and has been gradually increasing it.

Based on those ratio measures, we can see that despite having a lower Times Interest Earned ratio, company B is an overall better choice.

All this brings us to the next point – is a good Times Interest Earned ratio? What does a good TIE ratio even mean?

What Is a Good TIE Ratio

A good TIE (Times Interest Earned) ratio is generally considered to be 2 or higher, indicating that a company is generating enough income to cover its interest payments at least twice over. This suggests that the company is financially stable and has a lower risk of defaulting on its debt obligations.

However, you have to keep in mind that what constitutes a “good” Interest Coverage ratio can vary depending on the industry and the specific circumstances of the company. For example, companies in industries with high capital expenditures or cyclical revenues may require a higher Times Interest Earned ratio to be considered financially stable, as they may be more susceptible to fluctuations in their earnings.

In general, whenever talking about a good Times Interest Earned ratio, it is important to consider other financial metrics and factors such as industry benchmarks, market trends, and the company’s overall financial health and growth prospects. By focusing on more than just the TIE ratio, you get a more comprehensive view of the company’s financial position.

Can you have a negative times interest earned ratio? 

The answer is yes, the TIE ratio can be negative. This means that the company’s current income is not enough to cover its interest expense.

Why Is Times Interest Earned Ratio Important for Business 

The Times Interest Earned ratio can be very helpful in decision-making, as it provides information about a company’s financial health and ability to manage its debt obligations. By analyzing it, investors and analysts can make informed decisions about whether to invest in or lend money to the company.

For example, a low TIE ratio may indicate that a company is taking on too much debt and may struggle to meet its interest payments. This could suggest that the company is not managing its finances well and may be at risk of defaulting on its debt. As a result, an investor or analyst may decide to avoid doing business with it, whether that be investing or lending money.

On the other hand, a high TIE ratio suggests that a company is generating enough income to cover its interest payments and is financially stable, which can make the company more attractive to investors and lenders, and might even get them lower interest rates.

Additionally, the TIE ratio can provide insight into a company’s efficiency in generating earnings. A higher TIE ratio suggests that a company is generating a greater amount of earnings relative to its interest expense. This can indicate that the company is efficiently utilizing its resources to generate profits, which can make it a more attractive investment opportunity.

What Is the Difference between Times Interest Earned Ratio and Solvency Ratio

There isn’t much of a difference as the Times Interest Earned ratio is a type of solvency ratio. Solvency ratios are used as a way to assess how likely a company is to meet its long-term financial obligations, specifically in terms of debt repayment (both the principal and interest expense).

The Bottom Line

Knowing the financial situation of companies you want to invest in is one of the most important parts of being an investor – if you don’t know if a company has debts and whether they are regularly paying them off, you cannot make a fully conscious decision whether to invest or not.

Thankfully, there are several financial ratios that help you assess what’s the financial reality, and the TIE ratio is one of them. By now, you should know what it is, how to calculate TIE, and why it’s important to do so. After all, there’s a reason why it’s a crucial metric for business development.

With that being said, we have reached the end of our short guide on the TIE ratio. If you’re interested in other financial topics, don’t hesitate to take a look at our blog section.