The times interest earned (TIE) ratio, also known as the interest coverage ratio, is an important financial metric that measures a company’s ability to meet its debt obligations Specifically, the TIE ratio compares a company’s earnings before interest and taxes (EBIT) to its interest expenses over a given period
The TIE ratio is a liquidity and leverage ratio that creditors and investors often use to determine the riskiness of lending money to or investing in a company. A higher TIE ratio generally indicates a company is more capable of meeting its interest expenses and paying back its debts while a lower ratio may indicate higher risk of default.
Below we will look at the step-by-step process for calculating the TIE ratio, explain what constitutes a good or bad ratio, provide an example calculation, and outline why the metric is useful for financial analysis.
How to Calculate the TIE Ratio
The TIE ratio is calculated by dividing a company’s EBIT by its interest expenses over a specified period, such as a quarter or fiscal year.
The basic formula is:
Times Interest Earned (TIE) Ratio = EBIT / Interest Expense
Where:
- EBIT = Earnings Before Interest and Taxes
- Interest Expense = The company’s total interest expenses over a period
Let’s look at the step-by-step process:
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Determine the company’s EBIT over the desired period. This can be found on the income statement.
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Identify the company’s total interest expense over the same period. This will also be located on the income statement.
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Divide EBIT by the interest expense to get the TIE ratio.
Most analysts will look at the TIE ratio over several historical periods to identify trends and compare to industry benchmarks. It is also useful to calculate projected future TIE ratios based on financial forecasts.
What Constitutes a Good or Bad TIE Ratio?
While there are no hard limits on what makes a good or bad TIE ratio, most analysts agree on general guidelines:
- A ratio below 1.5x indicates high risk of default on debt obligations
- A ratio between 1.5x and 3.0x is generally acceptable
- A ratio above 3.0x is considered quite safe and low risk
As with any financial metric, the TIE ratio should be assessed in the context of the company’s industry and current economic environment. For example, a capital-intensive utility company may normally operate with a lower ratio than a software company. And periods of high interest rates will strain most companies’ ratios.
Comparing a company’s current TIE ratio to its historical average can highlight improving or worsening trends. Comparing across industry peers also provides useful perspective on relative credit risk.
Example of the Times Interest Earned Ratio Calculation
Below is a simple example TIE ratio calculation for a company’s 2022 fiscal year results:
2022 Income Statement
Revenue: $1,000,000
Operating Expenses: $700,000
EBIT: $300,000
Interest Expense: $100,000
Net Income: $200,000
TIE Ratio Calculation
EBIT: $300,000
Interest Expense: $100,000
TIE Ratio = EBIT / Interest Expense
= $300,000 / $100,000
= 3.0x
This TIE ratio of 3.0x indicates the company is in a fairly low risk position, earning operating income equal to 3 times its interest expense. It should have little trouble servicing its current debt based on 2022 earnings.
Why the TIE Ratio Is Useful for Financial Analysis
The TIE ratio provides important insights for both equity and debt investors when analyzing a company:
- Helps assess default risk on debt obligations
- Tests company’s ability to take on additional leverage
- Gauges operating efficiency and profit margins
- Identifies trends in performance over time
- Allows comparison to industry benchmarks
Creditors specifically can use the TIE ratio when deciding whether to extend financing, the appropriate size of the loan, and the interest rate to charge. The higher the ratio, the more risk tolerance when structuring a loan package.
Likewise, stock analysts will monitor the TIE ratio to avoid investing in companies at high risk of financial distress. And company management will keep a close eye on their TIE ratios to ensure they maintain access to affordable capital.
Formula and Calculation of the Times Interest Earned (TIE) Ratio
Assume, for example, that XYZ Company has $10 million in 4% debt outstanding and $10 million in common stock. The company needs to raise more capital to purchase equipment. The cost of capital for issuing more debt is an annual interest rate of 6%. The companys shareholders expect an annual dividend payment of 8% plus growth in the stock price of XYZ.
The business decides to issue $10 million in additional debt. Its total annual interest expense will be (4% X $10 million) + (6% X $10 million), or $1 million annually. The companys EBIT is $3 million.
This means that the TIE ratio for XYZ Company is 3, or three times the annual interest expense.
What the TIE Ratio Can Tell You
Obviously, no company needs to cover its debts several times over in order to survive. However, the TIE ratio is an indication of a companys relative freedom from the constraints of debt. Generating enough cash flow to continue to invest in the business is better than merely having enough money to stave off bankruptcy.
A companys capitalization is the amount of money it has raised by issuing stock or debt, and those choices impact its TIE ratio. Businesses consider the cost of capital for stock and debt and use that cost to make decisions.
Companies that have consistent earnings, like utilities, tend to borrow more because they are good credit risks.
Times Interest Earned (Interest Coverage Ratio)
How do you calculate times interest earned ratio?
The Times Interest Earned ratio can be calculated by dividing a company’s earnings before interest and taxes (EBIT) by its periodic interest expense. The formula to calculate the ratio is: Where: Earnings Before Interest & Taxes (EBIT) – represents profit that the business has realized, without factoring in interest or tax payments
What is the times interest earned formula?
The times interest earned (TIE) formula was developed to help lenders qualify new borrowers based on the debts they’ve already accumulated. It gave the investors an idea of shareholder’s equity metric and interest accumulated to decide if they could fund them further. What is the times interest earned ratio?
What is times interest earned?
Times interest earned is an important financial ratio that allows creditors, lenders and investors to evaluate a company’s financial strength. You may learn how to calculate times interest earned and use it as a valuable tool for researching viable companies to invest in their stocks.
What is a times interest earned (tie) ratio?
The higher the ratio, the better, as it indicates how many times a company could pay off its debt with its earnings. The times interest earned (TIE) ratio is a measure of a company’s ability to meet its debt obligations based on its current income.
