Last Updated on May 16, 2022
A company’s financial health is calculated using several different metrics. One is the Times Interest Earned (TIE) ratio, also called the Interest Coverage Ratio.
Most companies need to borrow money occasionally to maintain or expand their business. However, if a company can’t meet its debt obligations, it could go bankrupt. The TIE ratio is a predictor of how likely borrowed funds will get repaid.
Here’s everything you need to know about the Times Interest Earned ratio, which includes how to calculate it and what it means for your business.
What Is the Times Interest Earned Ratio?
The Times Interest Earned Ratio measures a company’s ability to repay debt based on current operating income. It is essentially a numerical snapshot of a company’s credit health. The higher the TIE ratio, the more cash the company will have leftover after paying debt interest.
The TIE ratio’s primary purpose is to help measure the likelihood of a company defaulting on a new loan. This ratio allows banks or investors to determine loan terms, such as the interest rate and loan amount a company can safely take on.
Understanding How To Use the Times Interest Earned Ratio
To better understand the TIE ratio, it’s helpful to look at what the TIE ratio means to a business. It measures how easily a company can fulfill its debt obligations. A business that can’t pay fixed expenses runs the risk of bankruptcy.
A bank or investor would use the ratio to determine if a company might need to pay down other debts before taking on more. A business could use the ratio to ensure it is not risking solvency by taking on additional debt.
A higher TIE ratio indicates a higher discretionary income. In other words, the business can grow because there is money left over after paying debt interest to reinvest back into the business. It will have the necessary funds to invest in new equipment or expand.
While a low TIE ratio likely indicates a credit risk, investors can turn down companies with very high TIE ratios. Investors often view businesses with a high TIE ratio as risk-averse, meaning the company might not be reinvesting to expand the business, limiting the company’s growth. For this reason, a bank or investor will consider several different metrics before providing funding.
How To Calculate the Times Interest Earned Ratio
You will need two figures to calculate the TIE ratio. Both of these figures are on your company’s profit and loss statement:
- Earnings before interest and income taxes (EBIT)
- Interest expense
Use these numbers in this straightforward equation to determine your TIE ratio:
EBIT ÷ Interest Expense = Times Interest Earned ratio.
Here is an example:
A landscaping company applies for a loan to buy new lawn equipment. The bank will need to see financial statements. The company’s income statement shows it earned $200,000 of income before interest expenses and income tax. The company’s overall interest expense for the year was $10,000. Therefore, the company’s TIE ratio would be calculated as follows:
$200,000 (EBIT) ÷ $10,000 (Interest Expense) = 10 (TIE)
The company has a TIE ratio of 10. In other words, the company’s income is ten times greater than its annual interest expense, so it should be able to afford the additional interest expense on a new loan. Of course, a bank or investor will consider other factors, but it shouldn’t have a problem extending a loan to the company with a TIE of 10.
How Does the Times Interest Earned Ratio Apply to Consistent Earnings?
A higher TIE ratio often signifies a business has consistent earnings. In general, businesses with consistent revenues are better credit risks and likely will borrow more because they can. They won’t have to seek other ways to fund their company because banks are willing to lend to them.
New businesses and those with inconsistent earnings often have to issue stock to raise capital until they create consistent earnings. Then, they can turn to borrowing as a means of raising capital.
Where To Find More Resources on Accounting Tips
If you would like to learn more about accounting tips, altLINE has many resources available for you.
For a small business with little debt, tracking the TIE ratio might not be helpful. However, for a company with debt that might need to take on more, the TIE ratio can provide the business and potential creditors or investors with a snapshot of how likely it will repay an additional loan.
While you might not need to calculate your company’s times earned interest ratio right now, you will as your business grows. You’ll likely turn to outside funding opportunities, and it will be beneficial to regularly calculate your TIE ratio.
Grey is the Director of Marketing for altLINE by The Southern Bank. With 10 years’ experience in digital marketing, content creation and small business operations, he helps businesses find the information they need to make informed decisions about invoice factoring and A/R financing.