A:

There is no substantive difference between the interest coverage ratio and times interest earned (TIE); these are two names for the same measurements of business solvency. Coverage ratios, similar to liquidity ratios, express the ability of a firm to meet certain financial obligations. Investors use coverage ratios to track changes in company debt over time and as a tool of comparison among like companies. Lenders pay close attention to coverage ratios before granting further credit or assigning risk profiles to businesses. One common method of expressing debt relationships is the (TIE) or interest coverage ratio.

TIE can be calculated by dividing total interest payable from the earnings before interest, taxes, depreciation and amortization (EBITDA). EBITDA is an accounting category used to assess financial performance. For simplicity's sake, you may often see TIE calculated using earnings before interest and tax (EBIT) rather than EBITDA.

EBIT, EBITDA and total interest payable can be found within a company's income statement. You may see EBIT expressed as operating income. A ratio of 1 suggests that there is sufficient cash flow to pay off interest expenses on debt, but nothing else; a ratio of 5 shows that the company earns five times as much as it has to pay out in interest.

Higher values are generally considered to be more favorable than lower values. There is a point of diminishing value, however, for publicly traded companies; a TIE ratio that is too high may be an indication that the company is under-utilizing debt, limiting possible shareholder equity. Ostensibly, a company could yield greater returns, borrowing at a lower cost of capital than what it currently pays on its debts.

As a general rule, creditors worry when an interest coverage ratio falls beneath 2.5 or 3. Interest coverage ratios tend to vary among different industries, so it is most useful to compare similar competitors. It is common practice to create trendlines of TIE for a company to see year-to-year fluctuations in its ability to service its debts. If the interest coverage ratio for a company seems significantly out of line with either its historical average or the normal range for its industry, this could be a red flag.

There are limitations to any coverage ratios, including TIE. EBITDA and EBIT ignore changes in working capital, capital expenditures, taxes and interest. This is why coverage ratios are often assessed in conjunction with other financial ratios and with a review of the income statement, balance sheet and statement of cash flows.

Shareholders and bondholders have particular interest in TIE, since they are considered to be creditors of the company. A coverage ratio that is dropping suggests that the company may struggle to meet future debt payments, potentially reducing the stock price and damaging bond valuations.

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