Times Interest Earned Ratio

Times Interest Earned Ratio is a solvency ratio that evaluates the ability of a firm to repay its interest on the debt or the borrowing it has made. It is calculated as the ratio of EBIT (Earnings before Interest & Taxes) to Interest Expense.

A higher ratio is favorable as it indicates the Company is earning higher than it owes and will be able to service its obligations. In contrast, a lower ratio indicates the company may not be able to fulfill its obligation. Thus, it shows how many times of the earnings made by the business will be enough to cover the debt repayment and make the company financially stable and sustainable.

• Times interest earned ratio measures a company's ability to pay off debt. A higher percentage is better, while a lower ratio means it may struggle to pay debt.
• The formula's numerator includes EBIT, which stands for operating income before taxes. In addition, it represents the business's income after deducting the necessary expenses for its operation.
• The denominator in this calculation represents the total interest expenses, while EBIT divided by the total interest expenses indicates how frequently a company can meet its interest obligations.

The times interest earning ratio is an important financial metric that is commonly used by the management of the company as well as its investors, creditors and shareholders to understand the debt repayment capacity based on its earnings. It helps to calculate the number of times of the earnings made by the business that is required to repay the debts and clear the financial obligation.

It is necessary to keep track of the ability of the entity to cover its interest expense because it gives an idea about the financial health. A high times interest earned ratio equation will indicate a good level of earnings that it more than the interest to be repaid. A strong balance sheet is what every investor desires in order to take a positive investment decision about a company. It not only increases the faith and trust of investors but also raises the chance of the business to obtain more credit from lenders since they are sure to get back the money they decide to lend.

However, this is not the only criteria that is used to judge the creditworthiness off an entity. It should be used in combination with other internal and external factors that influence the business. It should also be noted that this metric of good times interest earned ratio can also be used assess the level up to which the management can plan to borrow so that it can handle its credit obligations easily without putting any unnecessary pressure on the company resources which can be utilized effectively for more productive purposes.

The formula used for the calculation of times interest earned ratio equation is given below. Let us try to analyse the same in detail.

Times Interest Earned Ratio Formula = EBIT/Total Interest Expense

The Times interest earned is easy to calculate and use.

• The numerator of the formula has EBIT, which is nothing but operating income before taxes, and this is the income generated purely from business after deducting the expenses that are incurred necessary to run that business.
• The denominator is the firm's total interest expense of the firm, which is a burden for the firm. When EBIT is divided by total interest expenses, it can be interpreted as how many times the firm is earning to cover its interest obligation.

Let’s see some simple to advanced practical examples to understand it better.

Example #1

Company XYZ has operating income before taxes of $150,000, and the total interest cost for the firm for the fiscal year was $30,000. You must compute Times Interest Earned Ratio based on the above information.

Solution

We can use the below formula to calculate Times Interest Earned Ratio

• EBIT: 150000
• Total Interest Expense: 30000

Calculation of Times Interest Earned Ratio can be done using the below formula as,

• = 150,000/30,00

Times Interest Earned Ratio will be -

• Times Interest Earned Ratio = 5 times.

Hence, the times' interest earned ratio is five times for XYZ.

Example #2

DHFL, one of the listed companies, has been losing its market capitalization in recent years as its share price has started deteriorating. From the average price of 620 per share, it has come down to 49 per share market price. The Analyst is trying to understand the reason for the same, and initializing wants to compute the solvency ratios.

You are required to compute Times Interest Earned Ratio from March 09 till March 18.

Solution

Here we are not given direct operating income, and hence we need to calculate the same per below:

We shall add sales and other income and deduct everything else except for interest expenses.

Calculation of EBIT for Mar -09

• EBIT = 619.76

Similarly, we can calculate EBIT for the remaining year.

Calculation of Times Interest Earned Ratio can be done using the below formula as,

• =619.76 - 495.64

Times Interest Earned Ratio will be -

• Times Interest Earned Ratio = 1.25

Similarly, we can calculate for the remaining years.

Example #3

Excel Industries have been facing liquidity crunches, and recently it has received an order for $650 million, but they lack funds to fulfill the order. The Debt to Equity Ratio (DE) is 2.50 already, and it wants to borrow more to fulfill the order. However, the Bank has asked the company to maintain a DE ratio maximum of 3 and Times Interest Earned Ratio at least 2, and at present, it is 2.5. It currently pays $12 million as interest, and if the new borrowing puts up additional pressure of $4 million, would the firm be able to maintain the Bank's condition?

You are required to compute Times Interest Earned Ratio post new 100% debt borrowing.

Solution

First, we need to develop EBIT, which shall be a reverse calculation.

Use the following data for calculation of times interest earned ratio

• Time Interest Earned Ratio: 2.5
• Total Interest Expenses: 12000000

Calculation of EBIT

2.5  = EBIT / 12,000,000

EBIT  = 12,000,000 x 2.5

• EBIT = 30,000,000

Calculation of Times Interest Earned Ratio can be done using the below formula as,

=30000000/16000000

Times Interest Earned Ratio will be -

• Times Interest Earned Ratio= 1.88 

Therefore, the firm would be required to reduce the loan amount and raise funds internally as the Bank will not accept the Times Interest Earned Ratio.

Example#4

We note from the above chart that Volvo's Times Interest Earned has been steadily increasing over the years. It is a good situation due to the company's increased capacity to pay the interests.

It is necessary to understand the implications of a good times interest earned ratio and what is means for the entity as a whole. For that we need to study the details given below.

• Analysts should consider a time series of the ratio. A single point ratio may not be an excellent measure as it may include one-time revenue or earnings. Companies with consistent earnings will have a consistent ratio over a while, thus indicating its better position to service debt.
• However, as per the times interest earned ratio analysis, smaller companies and startups which do not have consistent earnings will have a variable ratio over time. Thus, lenders do not prefer to give loans to such companies. Hence, these companies have higher equity and raise money from private equity and venture capitalists.
• The banks and financial lenders often look at various financial ratios to determine the solvency of the Company and whether it will be able to service its debt before taking on more debt. The banks often look at the debt ratio, debt-equity ratio, and Times interest earned ratio.
• The negative ratio indicates that the Company is in serious financial trouble.

There are various ways and means to improve or increase the ratio, which will also mean an increase in the creditworthiness and betterment of financial condition of the company. Some of the strategies adopted in the times interest earned ratio analysis are as follows:

• Reducing interest payments – This will include various things like keeping a control over borrowing and trying to grow by utilising the resources already existing in the business. This will also include negotiation with lenders to relax the terms of repayment, reduce the interest rate provide longer maturites, which will help in lowering the debt burden.
• Increase earnings- In order to boost revenue, the company should try to meet the customer demand through better and higher range of product offering, understand the competition and design strategies, increase customer base, improve quality and bring innovation.
• Cost saving – This is important to increase the profitability because even if the sales is high, if the cost is not under control, this will eat away the revenue earned, leaving behind very little amount to repay debt and meet business expenses.
• Pricing – The products should be strategically prices so that it is able to attract customer and meet the market demand in an affordable way. On the other hand, it should also be able to withstand competition and earning revenue at par or more than its competitors.
• Multiple Revenue streams – It is always better to spread a business in different directions of fields from where revenue will flow in and in turn increase the ratio. This will also ensure better management of market fluctuations.
• Good financial management – A robust financial planning, management and forecasting will help in increasing the revenue and profits and meet challenges easily.

Although a good measure of solvency, the average times interest earned ratio has its disadvantages. Let us have a look at the flaws and disadvantages of calculating the Times interest earned ratio:

• Earnings Before Interest and tax used in the numerator is an accounting figure that may not represent enough cash generated by the Company. The ratio could be higher, but this does not indicate the Company has actual cash to pay the interest expense.
• The amount of interest expense used in the ratio's denominator is again an accounting measurement. It may include a discount or premium on the sale of the bonds and may not include the actual interest expense to be paid. To avoid such issues, it is advisable to use the interest rate on the face of the bonds.
• The average times interest earned ratio only considers the interest expenses. It does not account for principal payments. The principal payments may be huge and lead the Company to insolvency. Further, the Company may be bankrupt or have to refinance at the higher interest rate and unfavorable terms. Thus, while analyzing the solvency of the Company, other ratios like debt-equity and debt ratio should also be considered.

This article has been a guide to what is Times Interest Earned Ratio. We explained formula & interpretation along with examples, how to improve & limitations. You may learn more about ratio analysis from the following articles –

• Equity Ratio
• Importance and uses of Ratio Analysis
• Interpret ROCE
• Return on Assets Formula