Times interest earned ratio: Formula, definition, and analysis
Understanding why the times interest earned ratio is an essential metric for businesses to make informed decisions.
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1 minute
October 11, 2024
The times interest earned ratio assesses how well a business generates earnings to make interest payments on debt.
This article explores the times interest earned (TIE) ratio, provides several examples of its application, and explains how your business can improve the ratio’s value over time.
Key highlights:
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The times interest earned ratio (TIE) measures a company’s ability to make interest payments on all debt obligations. This metric is also known as the interest coverage ratio.
The times interest earned formula is EBIT (company’s earnings before interest and taxes) divided by total interest expense on debt. Debts may include notes payable, lines of credit, and interest obligations on bonds.
To calculate the ratio, locate earnings before interest and taxes (EBIT) in the multi-step income statement, and interest expense. A multi-step income statement provides more detail than a traditional income statement, and includes EBIT.
Businesses can raise capital by issuing equity, debt, or both. If a company raises capital using debt, management must determine if the business can generate sufficient earnings to make all interest payments on debt.
Companies may use other financial ratios to assess the ability to make debt repayment.
Companies are obligated to pay both interest and principal on debt. The debt service coverage ratio determines if a company can pay all interest and principal payments (also called debt service). The formula is (net operating income / debt service).
Firms also use the net debt to EBITDA ratio to determine if the business can repay all financial obligations. Note the following:
A company’s financial health depends on the total amount of debt, and the current income (earnings) the firm can generate. If the ratio is 3, for example, net debt is three times EBITDA.
Reducing net debt and increasing EBITDA improves a company’s financial health.
If any interest or principal payments are not paid on time, the borrower may be in default on the debt. A default impacts your ability to borrow in the future. If the debt is secured by company assets, the borrower may have to give up assets in the event of a default.
Fluctuations in the economy can impact default risk. If a business takes on additional debt after an increase in interest rates, the total annual interest expense will be higher. If operating expenses increase, current earnings may decline, and the firm’s creditworthiness may be affected.
Use accounting software to easily perform all of these ratio calculations. Using Excel spreadsheets for calculations is time consuming and increases the risk of error.
Assume that East Coast Construction generates $12 million in EBIT during 2022, and that the business pays $3 million in interest expense. TIE is ($12 million EBIT / $3 million interest expense), or 4.
In 2023, East Coast takes on more debt to finance a business expansion. However, the company only generates $10 million in EBIT during 2022, and the business pays $4 million in interest expense. TIE is ($10 million / $4 million), or 2.5.
Solvency ratios determine a firm’s ability to meet all long-term obligations, including debt payments. TIE is a solvency ratio.
Keep in mind that earnings must be collected in cash to make interest payments. While the TIE ratio does not account for cash, managers must collect sufficient cash to make interest payments.
Liquidity ratios analyze current assets and current liabilities, and current liabilities include interest payments due within a year. Working capital is a liquidity metric that is calculated as current assets less current liabilities, and businesses strive to maintain a positive working capital balance.
These two liquidity ratios are used to monitor cash collections, and to assess how quickly cash is paid for purchases.
Company founders must be able to generate earnings and cash inflows to manage interest expenses.
A high TIE ratio means that the business is generating more than enough earnings to pay all interest expenses. If the TIE ratio decreases, the company may be generating lower earnings or issuing more debt (or both).
In the example above, East Coast generated $2 million less in EBIT during 2023 vs. 2022. Interest expense increased by $1 million during the same period. As a result, the TIE declined from 4 in 2022 to 2.5 in 2023.
A lender may hesitate to loan to a business with a declining TIE. If earnings are decreasing while interest expense is increasing, it will be more difficult to make all interest payments.
Companies that can generate consistent earnings, such as many utility companies, may carry more debt on the balance sheet. Lenders are interested in the number of times a business can increase earnings without taking on more debt, and this situation improves the TIE ratio.
Many well-established businesses can produce more than enough earnings to make all interest payments, and these firms can produce a good TIE ratio.
Determining if your firm’s TIE ratio is financially healthy depends on your industry and your capital structure.
Capital-intensive businesses require a large amount of capital to operate. Banks, for example, have to build and staff physical bank locations and make large investments in IT. Manufacturers make large investments in machinery, equipment, and other fixed assets.
If your firm must raise a large amount of capital, you may use both equity and debt, and debt generates interest expense. Lenders are interested in companies that generate consistent earnings, which is why the TIE ratio is important.
This 2020 report from the Federal Reserve reports that the median interest coverage ratio (ICR) for publicly listed nonfinancial corporations is 1.59. As mentioned above, TIE is also referred to as the interest coverage ratio.
This source provides the 2021 median ICR ratio for a number of industries, based on publicly traded U.S. companies that submit financial statements to the SEC. To determine a financially healthy ratio for your industry, research industry publications and public financial statements.
Companies may use earnings to pay dividends to shareholders, or retain earnings to fund business operations. Ideally, a business should generate enough earnings to pay for interest expenses and to fund other needs. A TIE ratio of 2 or higher is a good starting point.
You can improve the TIE ratio by using automation, increasing earnings, and lowering costs.
Spend management encompasses organization-wide spending, accounting for invoice (accounts payable) and non-invoice (T&E) spend. Spend management software gives businesses a more comprehensive overview of cash flow and expenses, and Rho fully automates the process for you.
Businesses can increase EBIT by reviewing business operations in order to increase profit margins.
If some of your products or services are in high demand, you may be able to increase prices while maintaining the same level of sales.
Review all of the costs you incur, and identify areas where costs can be reduced. Evaluate your suppliers, and consider adding more vendors. If you can purchase a product through multiple suppliers, you can force the suppliers to compete for your business and offer lower prices.
Attempt to negotiate better terms on leases and other fixed costs to lower total expenses.
Create and enforce a formal collection process to avoid incurring bad debt expenses, which decrease earnings.
Successful businesses have a formal process to follow up on late payments. For example, your firm may email customers when an invoice is 30 days old and call clients if an invoice reaches 45 days old. Non-responsive customers should be sent to collections for more follow-up.
You can reduce interest expenses by refinancing existing debts. Another strategy is to use available cash flow to pay down debt faster and eliminate some of your interest expense.
Any business that raises capital by issuing debt should monitor the time interest earned ratio. Managers should review the ratio at least monthly. Before taking on additional debt, consider how the TIE ratio will be impacted.
Here are some frequently asked questions and answers about the times interest earned ratio:
The times interest earned formula is EBIT (earnings before interest and taxes) divided by total interest expense on debts. Debts may include notes payable, lines of credit, and interest expense on bonds.
The times interest earned ratio measures a company’s ability to make interest payments on all debt obligations.
Yes. A higher times interest earned ratio means that the business is generating more earnings, or that the business has reduced total interest expense — or both.
Monitoring the times interest earned ratio can help you make informed decisions about generating sufficient earnings to make interest payments, and decisions about taking on more debt. Rho’s platform is an ideal solution for managing all expenses and payments.
Rho’s AP automation helps process payables in a single workflow — from invoice to payment — with integrated accounting, and Rho fully automates expense management.
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Competitive data was collected as of February 26th, 2024, and is subject to change or update.
Rho is a fintech company and not a bank. Banking services provided by Webster Bank, N.A., Member FDIC.