What Is the Interest Coverage Ratio?

A TIE ratio of 5 means you earn enough money to afford 5 times the amount of your current debt interest — and could probably take on a little more debt if necessary. However, a company with an excessively high TIE ratio could indicate a lack of productive investment by the company’s management. This may cause the company to face a lack of profitability and challenges related to sustained growth in the long term. Successful businesses have a formal process to follow up on late payments. For example, your firm may email customers when an invoice is 30 days old and call clients if an invoice reaches 45 days old. Non-responsive customers should be sent to collections for more follow-up.

The Times Interest Earned (TIE) ratio measures a company’s ability to meet its debt obligations on a periodic basis. This ratio can be calculated by dividing a company’s EBIT by its periodic interest expense. The ratio shows the number of times that a company could, theoretically, pay its periodic interest expenses should it devote all of its EBIT to debt repayment. If a company has a low or negative times interest ratio, it means that debt service might consume a significant portion of its operating expenses. Conversely, if a company’s debt payments consistently surpass its revenue, it can prevent defaulting on obligations, such as paying salaries, accounts payable, and income tax. 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.

Times Interest Earned Ratio Calculation Example

In this exercise, we’ll be comparing the net income of a company with vs. without growing interest expense payments. While there aren’t necessarily strict parameters that apply to all companies, a TIE ratio above 2.0x is considered to be the minimum acceptable range, with 3.0x+ being preferred. Businesses can increase EBIT by reviewing business operations in order to increase profit margins. Company founders must be able to generate earnings and cash inflows to manage interest expenses.

Operating Income Calculation (EBIT)

1. DHFL, one of the listed companies, has been losing its market capitalization in recent years as its share price has started deteriorating.
2. Interest expense and income taxes are often reported separately from the normal operating expenses for solvency analysis purposes.
3. While the TIE ratio does not account for cash, managers must collect sufficient cash to make interest payments.
4. A company’s ratio should be evaluated to others in the same industry or those with similar business models and revenue numbers.
5. Keep in mind that earnings must be collected in cash to make interest payments.
6. If a company can no longer make interest payments on its debt, it is most likely not solvent.

When you sit down with the financial planner to determine your TIE ratio, they plug your EBIT and your interest expense into the TIE formula. Simply put, your revenues minus your operating costs and expenses equals your EBIT. In a perfect world, companies would use accounting software and diligence to know their position and not consider a hefty new loan or expense they couldn’t safely pay off. But even a genius CEO can be a tad overzealous and watch as compound interest capsizes their boat.

If the TIE ratio decreases, the company may be generating lower earnings or issuing more debt (or both). Dill’s founders are still paying off the startup loan they took at opening, which was $1,000,000. Last year they went to a second bank, seeking a loan for a billboard property and equipment definition campaign. The founders each have “company credit cards” they use to furnish their houses and take vacations. The total balance on those credit cards is $50,000 with an annual interest rate of 20 percent. If you have a $10,000 line of credit with a 10 percent monthly interest rate, your current expected interest will be $1,000 this month.

Free Financial Modeling Lessons

The TIE ratio reflects the number of times that a company could pay off its interest expense using its operating income. Interest expense and income taxes are often reported separately from the normal operating expenses for solvency analysis purposes. This also makes it easier to find the earnings before interest and taxes or EBIT. A high TIE means that a company likely has a lower probability of defaulting on its loans, making it a safer investment opportunity for debt providers. Conversely, a low TIE indicates that a company has a higher chance of defaulting, as it has less money available to dedicate to debt repayment. A high TIE ratio means that the business is generating more than enough earnings to pay all interest expenses.

So long as you make dents in your debts, your interest expenses will decrease month to month. But at a given moment, this amount can be hundreds or thousands of dollars piling onto your plate, in addition to your regular payments and other business expenses. The times interest earned formula is calculated on your gross revenue that is registered on your income statement, before any loan or tax obligations. The ratio is not calculated by dividing net income with total interest expense for one particular accounting period. It is only a supporting metric of the financial stability and cash arm of your business which determines that you have the ability to clear off your liabilities with whatever you earn.

This ratio is crucial for investors, creditors, and analysts as it provides insight into the company’s financial health and stability. A higher TIE ratio suggests that the company is generating sufficient earnings to comfortably cover its interest payments, indicating lower financial risk. Conversely, a lower TIE ratio may signal financial distress, where the company struggles to manage its interest payments, posing a higher risk to creditors and investors. Solvency ratios determine a firm’s ability to meet all long-term obligations, including debt payments.

Calculating total interest earned

As a general rule of thumb, the higher the times interest earned ratio, the more capable the company is at paying off its interest expense on time (and vice versa). In other words, a ratio of 4 means that a company makes enough income to pay for its total interest expense 4 times over. Said another way, this company’s income is 4 times higher than its interest expense for the year. Here, we can see that Harrys’ TIE ratio increased five-fold from 2015 to 2018. This indicates that Harry’s is managing its creditworthiness well, as it is continually able to increase its profitability without taking on additional debt.

This 2020 report from the Federal Reserve reports that the median interest coverage ratio (ICR) for publicly listed nonfinancial corporations is 1.59. As mentioned above, TIE is also referred to as the interest coverage ratio. Due to Hold the Mustard’s success, your family is debating a major renovation that would cost $100,000. Here, Company A is depicting an upside scenario where the operating profit is increasing while interest expense remains constant (i.e. straight-lined) throughout the projection period. Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career.

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The steps to calculate the times interest earned ratio (TIE) are as follows. A higher ratio suggests that the company is more likely to be able to meet its interest obligations, reducing the risk of default. We will also provide examples to clarify the formula for the times interest earned ratio. Rho’s AP automation helps process payables in a single workflow — from invoice to payment — with integrated accounting, and Rho fully automates expense management. Another strategy is to use available cash flow to pay down debt faster and eliminate some of your interest expense.

Review all of the costs you incur, and identify areas where costs can be reduced. If you can purchase a product through multiple suppliers, you can force the suppliers to compete for your business and offer lower prices.

The Analyst is trying to understand the reason for the same, and initializing wants to compute the solvency ratios. The formula used for the calculation of times interest earned ratio equation is given favourable variance below. 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.