A:

There is no universally definable threshold for a times interest earned ratio that is too high. Each business must balance the possible reaction of creditors, who are looking for healthy companies with high ratios, and shareholders, who might grow concerned if a firm becomes too conservative with its earnings. If a times interest earned ratio is deemed too high, the only way to effectively lower it is to increase interest payment obligations and acquire more debt.

Calculating the Times Interest Earned Ratio

Times interest earned, also known as the "interest coverage ratio," is calculated by taking earnings before interest and taxes, or EBIT, and dividing it by total interest payable. Total interest payable refers to all the interest obligations for issued bonds and other contractual debt. A ratio of 1.0 means the company earns exactly enough revenue to cover its interest payments.

Lowering Times Interest Earned

Generally speaking, higher ratios are a signal of financial health, effective operations and solvency. There is a point, however, when a company can be too safe and its lack of debt is considered undesirable to shareholders. This is because debt can be used as leverage to expand and increase returns. Debt financing is relatively cheaper than equity financing and, in some cases, an increase in the gearing ratio might actually add value to the business.

Financial ratios can only be lowered by decreasing the value in the numerator or by increasing the value in the denominator. A company could theoretically shrink its revenue stream to reduce times interest earned, which is the numerator, but this does not strengthen returns and increases the risk of insolvency without any real payout. Instead, the company should look to strategically acquire additional debt, which is the denominator, and grow its earnings potential.

When confronted with a very high interest cover, the company could issue more bonds or look to take out a bank loan. This measure should not be done solely for the purpose of lowering times interest earned; the debt should serve some viable and productive business purpose.

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