What are Times Interest Earned Ratio?
Times interest earned ratio is among the commonly known and used financial ratios in marketing and finance. There are different ratios in which a company will need to calculate. These ratios help the companies in various ways, as discussed below:
What Are The Uses Of Financial Ratios?
- The financial ratios are used in measuring the financial performance of a company against its standards.
- Most financial ratios provide entrepreneurs with a way of Evaluation a Company’s performance.
- The proportions also help the company to compare its business with other similar companies.
- These ratios help measure and compare the relationships between different components of the financial statements.
- Financial ratios are also used in flash reports to improve the company’s financial performance per week.
Some of the financial ratios include:
The Quick Ratio Analysis
The quick ratio analysis is known as the acidic test ratio, which shows its ability to meet its short-term needs. You can do Quick ratio analysis by using liquid assets. Compared to the current ratio, they are almost the same, but there is just a small difference in which the quick ratio is considered to be more reliable when it comes to short-term strengths.
The quick ratio is used to measure the company’s ability to pay the current debts without depending on inventory sales.
The leverage ratios include:
- Debt-to-equity ratio measures the amount of debt a business is carrying compared to the shareholders’ investments. It is also known as the ability of the company to pay its debts.
- Debt-to-asset ratio, which indicates the percentage of business’s assets that the owners or the investors’ finance. If the ratio is too high, it suggests a specific dependence that may lead to financial weakness.
The liquidity ratios include:
- The working capital ratio is whether a company has enough cash flow to meet its short-term obligations. It also indicates whether a company can attract credit terms. (favorable ones)
- The cash ratio indicates a company’s ability to pay the sudden creditor demands using the available liquid assets.
Profitability ratios include:
- Net profit margin indicates the net/ total income given out from each dollar in the company sales. It measures the company’s sales revenue percentage after paying the interest, taxes, and operating expenses.
- Coverage ratio measures the business’s capacity to give out enough income to repay interests on the debts.
- Return on total assets, which indicates the efficiency of assets to pay the profits.
The operation ratios include:
- Inventory turnover, which measures the asset’s efficiency in profit generation
- Accounts receivable turnover where a high rate indicates that a low amount of money will be received at the end.
- Average day’s payable, which shows the average number of days it, takes to pay its suppliers.
- Average collection periods show the number of times customers take for their bill payment.
The Price-Earnings Growth Ratio
The Price to earnings growth ratio is the price-to-earnings stock ratio which is divided by the earnings growth rate. It is used to determine the value of the stock while factoring in the expected earnings. In most cases, the price-earnings ratio is more significant in companies with a high growth rate
Price-To-Book Value Ratio
You can use the price-to-book ratio to compare the company’s market value to the book value. To get the company’s market value, you must multiply the share price by outstanding shares.
Strengthening a Business Using Financial Ratios
Financial ratios give a different insight into a business. You can boost your business using the financial ratios as discussed below:
- By determining your relevant ratios as using certain ratios depend on the particular set goals. Some ratios are more advantageous in some companies and disadvantageous to other companies.
- Keeping your track overtime as you compare your results. Investigate what might have changed in the case of changes in your company’s profit margins.
- You can also benchmark your business.
- The ratios can be used to derive specific strategies that may help improve in company’s maximization of profits.
What is Times Interest Earned Ratio?
The Times interest earned ratio (TIE) is referred to as the measure of a company’s ability to meet the debt obligations, which is usually based on the available income. The Times Interest Earned ratio shows the number of times a particular company can pay its interest using the previous tax income.
In most cases, the larger ratios are more considerable as compared to the smaller ratios. For example, a times interest earned ratio of 5 is more favorable than the ratio of three. The ratio of five means that a company makes enough income that is five times the annual income. The ratio also means that a company experiences fewer risks to the investors.
What does the Times Interest Earned Ratio Indicate?
Most people define the Times interest earned ratio as the company’s financial solvency, that is if a company owns enough assets to meet or achieve its liabilities. The cash flow can change, but the bills remain constant as the bills have to be paid. The company’s times interest earned ratio shows the company’s ability to pay its creditors.
Sometimes, a company may get a times interest earned ratio of less than one; in such cases, the company cannot generate enough money for the operating earnings to perform the interest payments.
In other cases, the company may get a higher Times Interest Earned ratio that indicates that the company is not utilizing debts in its capital structure. The ratio reduces its interest cost.
A higher or greater times interest earned ratio indicates that:
- All operations in a business are profitable compared to the competitors, which results in higher earnings.
- It also shows that a company has less risk to its investors and creditors in terms of solvency.
A lower times interest earned ratio shows the above vice versa as the company will lack enough funds to pay its creditors.
Calculation of Times Interest Earned Ratio
Before calculating times, interest earned ratio; there are certain variables that you need to consider. Some of the variables are:
Earnings before Interest and Taxes (EBIT)
The EBIT represents the profits realized in the company or the business without factoring in the payment of taxes. This symbolizes the company’s total/net income before the tax expenses. In most cases, the Earnings Before interest and taxes are used in the analysis of the company’s performance. This tells you what the company gets from all its operations.
To get the EBIT, you are supposed to take the total revenue from sales and subtract the goods sold. This gives you the gross profit. Subtract the operating expenses from the gross profit. Now you will have the earnings before interest and tax interest.
Some problems may be experienced earnings before interests and taxes as discussed below:
A growing company may reach considerable trouble for it to regain or reduce the burden of taxes. Most of these taxes are long-term loans and other debts which can cause a company’s failure. These can be corrected by investing and operating in countries that offer low rates of income tax.
An entity that is publicly at the risk of being tempted to report its earnings before interest and taxes to the investment community is not encouraged by the body that dealt with security in the exchange measures. The security and exchange commission board mandates that reporting of such must be reconciled in an appropriate measure
The interest expenses represent the payment of debts within a certain duration which the company is required by the creditors, including loans from banks and different lenders. It also includes interests paid on obligations such as bonds.
Some people refer to the Times earned interest ratio as the coverage ratio. The coverage ratio is used to measure the amount of income the company can use to cover future interest expenses. In other cases, the people consider the TIE as a solvency ratio.
This is because the ratio is used to measure the firm’s ability to make interests and pay debts simultaneously. These interest payments are made on a long-term basis. Therefore, they are said to be ongoing expenses and also fixed costs. If the company is unable to pay debts, it is said to be in a bankruptcy state, and therefore the ratio is called the solvency ratio.
What is the formula for the calculation of the Times interest earned ratio?
The Times Interest Earned Ratio calculation is done by dividing the income before the interest and income taxes by interest expenses.
The Formula For The Calculation Of Times Interested Earned Ratio Can Be Obtained From The Following Steps.
- At first, you are required to know the interest expenses incurred by your business. You can get this from the income statement.
- Secondly, you have to determine all operating incomes got from the business. In case the operating incomes such as the EBIT are not provided in the statements (income statements), you can get it by adding the interest charges and all the taxes paid.
- In the third step, the formula for getting times interest earned ratio is derived through dividing the operating income got in step two by the company’s interest got in step one.
i.e. Times Interest Earned Ratio = (income tax before interest and taxes) ÷ interest expense.
You can take all these digits from the income statement, which has the interest expenses and the income tax. These are usually reported separately for solvency analysis. Reporting them separately is also reliable because you can trace the earnings and interests.
Example in a Question
Steven’s processing company applies for a loan to buy a new processing machine. The bank requires Steven to produce the company’s financial statements before considering his loan.
His statements state that he made an income of $800000 before interest expense and the total income tax. The total interest was $80000 in the year. Calculate Steven’s times earned interest ratio.
This will be $800000÷$80000 =10
Stevens times interest earned ratio is ten which means that his income is ten times greater than the annual expenses.
Calculation Of Times Interest Earned Ratio Using a calculator.
Certain calculators are designed for the calculation of times interest earned ratio. One of the calculators is called the Times interest earned calculator. Such calculators make work much more manageable.
Calculation of Coverage Ratio
In the beginning, we said that some people refer to the Times interest earned ratio as the coverage ratio. The two ratios are almost the same, but we will define both of them for you to note. Coverage ratio refers to the group of measurements that determine the capability of a company to pay its debts and serve all the financial requirements such as the liability to pay back in time.
If the coverage ratio is very high, it indicated that a company/ business has an increased ability to pay its debts. In contrast, a low coverage ratio indicates that a company may face difficulties while paying its debts.
Certain factors are considered in examining coverage ratio, such as; total interests, net income, total assets, and unpaid liabilities.
There Are Categories Of Coverage Ratio In Which We Have:
- The Interest Coverage Ratio is the company’s ability to pay back its interests within the time given.
- Debt Service Coverage- a company can pay a complete debt. All interests and principal are used in the calculation of debt service coverage.
- Asset Coverage Ratio: A company can pay a complete debt for owing the assets. These assets are tangible.
The coverage ratio is calculated using the following formula
Interest Coverage Ratio is equal to the Earnings before Interest and Taxes divided by Interest Expense
Analysis of the Times Interest Earned Ratio
The TIE Ratio is usually stated in numbers but not in percentages. This is because the ratio shows the number of times a company can pay the interest with its tax before income. This is why larger ratios are more considered and favorable as compared to smaller ratios.
Creditors are more likely to favor a company with a higher interest ratio because they consider the company to pay the interest payments in due time. When lenders lend you some money, they assess the likelihood of going to repay the money.
The TIE ratio indicates whether a company is running into trouble financially. Suppose a company has a more excellent ratio. In that case, this means that the company can meet the interest obligations because its earnings are relatively more significant compared to the annual interest expenses. A high ratio also indicates that the company has a low leverage level. The ratio also assesses if a company is earning enough to pay off all the interest expenses.
The analysis (trend analysis) gives out insight into the company’s ability to pay debts.
Realization of times interest earned ratio
There is no company that wishes to cover other debts for it to survive in most cases. The TIE ratio shows the relative freedom of a company from struggling while paying a debt. It is not an easy task for every company to generate enough money and ensure cash flow. There must be good management in the company for that to happen. Getting enough cash to invest is the dream of every company rather than bankruptcy.
Having a good TIE is better for a company that needs to grow. Most companies with consistent earning and utilities are more likely to borrow due to their credibility. They have a reasonable credit risk.
What Should A Company Do To Improve the Time Interest Ratio?
There are certain steps that a company should take for it to increase or improve on its Times interest earned ratio. Such steps include:
- Pay out Its Debts.
A company should reduce the number of debts which is taken on its balance sheet. This serves by just lowering its interest payments. It will help the company to retire some of its debts depending on the type of debt or the debt terms. Lowering the interest payments generally increases the company’s times interest earned ratio
- Increasing Equity Levels in the Capital Structure.
For a proper capitalization of a business, the company needs to issue debts and use equity as the source of capital. Reducing the debt proportions to equity also reduces the interest payment level of the company. Offering equity to investors is another way of paying down its debt, therefore increasing its capital. This increases the company’s time’s interest earned ratio.
- Increasing The Company Earnings
Increasing the company’s earnings is achieved by maximizing the company’s profits. When a company increases its profitability by increasing its sales, the earnings before interest and tax are also increased.
Decreasing the company’s expenses is also another way for the company to maximize its earnings and, therefore, to increase the Times interest earned ratio.
- Ensuring Consistent Earnings.
A company generating consistent earnings for a year is more likely to have the highest debt expressed as a total capital percentage. If the company produces the earnings statement, the lender will consider the company as creditworthy.
Problems in Times Interest Earned Ratio.
What Are Some Of The Problems Experienced In The Calculation Of Times Interest Earned Ratio?
A times interest earned ratio that is very low shows that there will be very few earnings to cater for the interest payments. The cases where a company fails to meet its obligations may force the company to a state of bankruptcy. Certain problems may be experienced while trying to achieve a high times interest earned ratio. Such flaws are discussed below:
- The earnings before interests and tax written as the numerator while calculating the times interest earned ratio may not be related to the cash generated. This may make the ratio excellent, but the business may lack enough funds to pay its debts and the interest charges. The reverse of this will also be valid when the ratio is too low, and the borrower will have a positive cash flow.
- The amount of the interest expenses, which are written as the denominator while calculating the Times interest earned ratio, may incorporate any discounts. It may also contain premiums such as bonds. This means that it will not be equal to the real/ actual interest expense. In such cases, you are advised to use your interest rate stated on the front of bonds.
- The Times interest earned ratio does not accountancy principal pay down. This may lead to the company’s bankruptcy state. It may also force the borrower to refinance at very high rates of interest.
The Times interest earned ratio has some advantages and disadvantages, which are discussed below:
The Advantages Include:
- The Times interest earned ratio is easy to calculate
- The ratio also shows the solvency of the company.
- This ratio also helps one compare different companies
- One can know if the company is stable when it comes to financial matters.
- When using earnings before interest and tax, the ratio got does not give a clear or the real, or understandable picture of the company’s stability
- Times interest earned ratio primarily focuses on the short-term abilities of the company.
- The earnings before interest and tax do not give the actual cash generated
- It does not take account of upcoming principal payments
The financial ratios mainly indicate the growth of a company either positively or negatively. They help us understand if a company is in a good state when payment of its debts. Investors use the financial ratios before investing in a specific company, and therefore it is good for you to keep good records of your company.
The Times interest earned ratio shows if a company can generate enough operating earnings to pay expenses. In most cases, the creditors are more likely to lend their money to a company with a high Times interest earned ratio. You must know the Times Interest Earned Ratio of your company. Having read through this article, you now have understood the importance of the Times interest earned ratio of your company. I hope you are also aware of different ways to improve your earnings, which helps progress.
My Name is Nadeem Shaikh the founder of nadeemacademy.com. I am a Qualified Chartered Accountant, B. com and M.Com. having professional and specialize experience in field of Account, Finance, and Taxation. Total experience of 20 years in providing businesses solution in Taxation, Accounting, and Finance with all statutory compliance with timely business performance Financials reports. You can contact me on [email protected] or [email protected]