A common solvency ratio utilized by both creditors and investors is the times interest earned ratio. Often referred to as the interest coverage ratio, the times interest earned ratio depicts a company's ability to cover the interest owed on debt obligations, expressed as income before interest and taxes divided by interest expense.
- The times interest earned ratio is a solvency metric that evaluates how well a company can cover its debt obligations.
- It is calculated by dividing a company's EBIT by its interest expense, though variations change both of these figures.
- A high times interest earned ratio typically means a company has stronger performance and is less risky.
- However, a high calculation could also mean a company is not prioritizing growth and may not be a strong long-term investment.
- Like other ratios, there are a number of limitations to consider when using the times interest earned ratio.
What Is Times Interest Earned Ratio?
The ratio is stated as a number as opposed to a percentage, and the figures necessary to calculate the times interest earned are found easily on a company's income statement. For example, a ratio of 5 means the business is able to meet the total interest payments owed on its outstanding, long-term debt five times over, or that the business income is five times higher than the interest expenses owed for the year.
Times Interest Earned Ratio Formula
The times interest earned ratio is a company's earnings before interest and taxes divided by a company's interest payable on bond and debt obligations:
Earnings Before Interest and Taxes / Interest Expense
Assume a company has $5 million of debt outstanding at a rate of 5% and EBIT of $1 million. Based on the company's debt and rate, the company is expecting to be assessed $250,000 ($5 million * 5%) of debt. The company's high times earned ratio is 4 ($1 million / $250,000).
What a High Times Interest Earned Ratio Can Tell You
A higher times interest earned ratio is favorable because it means that the company presents less of a risk to investors and creditors in terms of solvency. From an investor or creditor's perspective, an organization that has a times interest earned ratio greater than 2.5 is considered an acceptable risk. Companies that have a times interest earned ratio of less than 2.5 are considered a much higher risk for bankruptcy or default.
A times interest earned ratio can also be inefficiently high. A business can choose to not utilize excess income for reinvestment in the company through expansion or new projects, but rather pay down debt obligations. For this reason, a company with a high times interest earned ratio may lose favor with long-term investors.
To determine whether a times interest earned ratio is high, consider calculating the ratio several times over a specified period. By analyzing a company's results over time, you will better understand whether a high calculation is standard or a one-time fluke.
Limitations of Times Interest Earned Ratio
The times interest earned ratio is highly dependent on industry metrics. Every sector is financed differently and has varying capital requirements. Therefore, while a company may have a seemingly high calculation, the company may actually have the lowest calculation compared to similar companies in the same industry.
The ratio is also dependent on stable earnings. If the company doesn't earn consistent revenue or experiences an unusual period of activity, this period will distort the realistic operations of the business. This is also true for seasonal companies that may generate unfairly low calculations during slower seasons.
Because cash is not considered when calculating EBIT, there is the risk that the company is not actually generated enough cashflow to pay its debts. If a substantial portion of a company's revenue is credit sales to be paid in future installments, the times interest earned ratio will fail to detect that the company may not have enough money on hand to pay interest. This is true even if the company is recording enough revenue.
To get a better sense of cashflow, consider calculating the times interest earned ratio using EBITDA instead of EBIT. This variation more closely ties to actual cash received in a given period.
The times interest earned ratio is also somewhat biased towards larger, more established companies in safer sectors due to credit terms and interest rates. Imagine two companies that earn the same amount of revenue and carry the same amount of debt. However, because one company is younger and is in a riskier industry, its debt may be assessed a rate twice as high. In this case, one company's ratio is more favorable even though the composition of both companies is the same.
Last, the times interest earned ratio doesn't include principal payments. While a company might have more than enough revenue to cover interest payments, it may be facing principal obligations coming due that it won't be able to pay for.
What Is Times Interest Earned Ratio?
Times interest earned ratio is a solvency metric that evaluates whether a company is earning enough money to pay its debt. It specifically compares the income a company makes prior to interest and taxes to what interest expense it must pay on its debt obligations.
What Is a Good High or Low Times Interest Earned Ratio?
The times interest earned ratio is usually different across industries. In general, it's best to have a times interest earned ratio that demonstrates the company can earn multiple times its annual debt obligation. It's often cited that a company should have a times interest earned ratio of at least 2.5.
How Can You Find Times Interest Earned Ratio?
The times interest earned ratio is calculated by dividing a company's EBIT by the company's annual debt obligations.
The Bottom Line
The times interest earned ratio is a measurement of a company's solvency. While a higher calculation is often better, high ratios may also be an indicator that a company is not being efficient or not prioritizing business growth.