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 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.
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 and, therefore, financially unstable.
Although a higher times interest earned ratio is favorable, it does not necessarily mean that a company is managing its debt repayments or its financial leverage in the most efficient way. Instead, a times interest earned ratio that is far above the industry average points to misappropriation of earnings. This means the business is not utilizing excess income for reinvestment in the company through expansion or new projects, but rather paying down debt obligations too quickly. A company with a high times interest earned ratio may lose favor with long-term investors.