What Is the Times Interest Earned Ratio?
The times interest earned (TIE) ratio is a measure of a company's ability to meet its debt obligations based on its current income. The formula for a company's TIE number is earnings before interest and taxes (EBIT) divided by the total interest payable on bonds and other debt.
The result is a number that shows how many times a company could cover its interest charges with its pretax earnings.
TIE is also referred to as the interest coverage ratio.
Times Interest Earned (TIE)
- A company's TIE indicates its ability to pay its debts.
- A better TIE number means a company has enough cash after paying its debts to continue to invest in the business.
- The formula for TIE is calculated as earnings before interest and taxes divided by total interest payable on debt.
Understanding the Times Interest Earned (TIE) Ratio
Obviously, no company needs to cover its debts several times over in order to survive. However, the TIE ratio is an indication of a company's relative freedom from the constraints of debt. Generating enough cash flow to continue to invest in the business is better than merely having enough money to stave off bankruptcy.
A company's capitalization is the amount of money it has raised by issuing stock or debt, and those choices impact its TIE ratio. Businesses consider the cost of capital for stock and debt and use that cost to make decisions.
How to Calculate Times Interest Earned (TIE)
Assume, for example, that XYZ Company has $10 million in 4% debt outstanding and $10 million in common stock. The company needs to raise more capital to purchase equipment. The cost of capital for issuing more debt is an annual interest rate of 6%. The company's shareholders expect an annual dividend payment of 8% plus growth in the stock price of XYZ.
Companies that have consistent earnings, like utilities, tend to borrow more because they are good credit risks.
The business decides to issue $10 million in additional debt. Its total annual interest expense will be: (4% X $10 million) + (6% X $10 million), or $1 million annually. The company's EBIT is $3 million.
This means that the TIE ratio for XYZ Company is 3, or three times the annual interest expense.
Factoring in Consistent Earnings
As a rule, companies that generate consistent annual earnings are likely to carry more debt as a percentage of total capitalization. If a lender sees a history of generating consistent earnings, the firm will be considered a better credit risk.
Utility companies, for example, generate consistent earnings. Their product is not an optional expense for consumers or businesses. Some utility companies raise 60% or more of their capital by issuing debt.
Startup firms and businesses that have inconsistent earnings, on the other hand, raise most or all of the capital they use by issuing stock. Once a company establishes a track record of producing reliable earnings, it may begin raising capital through debt offerings as well.