What Does Times Interest Earned Mean?
Times interest earned (TIE) is a metric used to measure a company's ability to meet its debt obligations. The formula is calculated by taking a company's earnings before interest and taxes (EBIT) and dividing it by the total interest payable on bonds and other contractual debt. TIE indicates how many times a company can cover its interest charges on a pretax earnings basis.
Times Interest Earned (TIE)
Understanding Times Interest Earned (TIE)
Generating cash flow to make principal and interest payments and avoiding bankruptcy depends on a company's ability to produce earnings. A company's capitalization refers to the amount of money it has raised by issuing stock or debt and choices about capitalization impact the TIE ratio. Businesses consider the cost of capital for stock and debt and they use that cost to make decisions about capitalization.
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 and that the firm needs to raise more capital to purchase equipment. The cost of capital for issuing more debt is an annual interest rate of 6% and shareholders expect an annual dividend payment of 8%, plus appreciation in the stock price of XYZ. The business decides to issue $10 million in additional debt and the firm determines that the total annual interest expense is: (4% X $10 million) + (6% X $10 million), or $1 million annually. The company's EBIT calculation is $3 million, which means that the TIE is 3, or three times the annual interest expense (interest payable).
Factoring in Consistent Earnings
Companies that generate consistent annual earnings are more likely to carry more debt as a percentage of total capitalization. If a lender sees a history of generating consistent earnings, the firm is in a better position to make principal and interest payments on time. Utility companies, for example, provide a product that consumers use every month and these firms generate consistent earnings. As a result, some utility companies may raise 60% or more of their capital from issuing debt.
Startup firms and other businesses that have inconsistent earnings raise most, or all of the company capital using equity – that is, stock. Once a company can establish a track record of producing reliable earnings, it may raise capital through debt offerings and shift away from issuing common stock.