What is the Times Interest Earned Ratio?

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Times Interest Earning Ratio Formula

Times Interest Earned Ratio Formula = EBIT/Total Interest Expense

The Times interest earned is easy to calculate and use.

  • The numerator of the formula has EBITEBITEarnings before interest and tax (EBIT) refers to the company’s operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization’s profit from business operations while excluding all taxes and costs of capital.read more, which is nothing but operating incomeOperating IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business.read more before taxes, and this is the income generated purely from business after deducting the expenses that are incurred necessary to run that business.The denominator is the firm’s total interest expense of the firmInterest Expense Of The FirmInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more, which is a burden for the firm. When EBIT is divided by total interest expenses, it can be interpreted as how many times the firm is earning to cover its interest obligation.

Examples

Let’s see some simple to advanced practical examples to understand it better.

Example #1

Company XYZ has operating income before taxes of $150,000, and the total interest cost for the firm for the fiscal yearFiscal YearFiscal Year (FY) is referred to as a period lasting for twelve months and is used for budgeting, account keeping and all the other financial reporting for industries. Some of the most commonly used Fiscal Years by businesses all over the world are: 1st January to 31st December, 1st April to 31st March, 1st July to 30th June and 1st October to 30th Septemberread more was $30,000. You must compute Times Interest Earned Ratio based on the above information.

Solution

We can use the below formula to calculate Times Interest Earned Ratio

  • EBIT: 150000Total Interest Expense: 30000

Calculation of Times Interest Earned Ratio can be done using the below formula as,

  • = 150,000/30,00

Times Interest Earned Ratio will be –

  • Times Interest Earned Ratio = 5 times.

Hence, the times’ interest earned ratio is five times for XYZ.

Example #2

DHFL, one of the listed companies, has been losing its market capitalization in recent years as its share price has started deteriorating. From the average price of 620 per share, it has come down to 49 per share market price. The Analyst is trying to understand the reason for the same, and initializing wants to compute the solvency ratiosSolvency RatiosSolvency Ratios are the ratios which are calculated to judge the financial position of the organization from a long-term solvency point of view. These ratios measure the firm’s ability to satisfy its long-term obligations and are closely tracked by investors to understand and appreciate the ability of the business to meet its long-term liabilities and help them in decision making for long-term investment of their funds in the business.read more.

You are required to compute Times Interest Earned Ratio from March 09 till March 18.

Here we are not given direct operating income, and hence we need to calculate the same per below:

We shall add sales and other income and deduct everything else except for interest expenses.

Calculation of EBIT for Mar -09

  • EBIT = 619.76

Similarly, we can calculate EBIT for the remaining year.

  • =619.76 – 495.64

  • Times Interest Earned Ratio = 1.25

Similarly, we can calculate for the remaining years.

Example #3

Excel Industries have been facing liquidity crunches, and recently it has received an order for $650 million, but they lack funds to fulfill the order. The Debt to Equity RatioDebt To Equity RatioThe debt to equity ratio is a representation of the company’s capital structure that determines the proportion of external liabilities to the shareholders’ equity. It helps the investors determine the organization’s leverage position and risk level. read more (DE) is 2.50 already, and it wants to borrow more to fulfill the order. However, the Bank has asked the company to maintain a DE ratio maximum of 3 and Times Interest Earned Ratio at least 2, and at present, it is 2.5. It currently pays $12 million as interest, and if the new borrowing puts up additional pressure of $4 million, would the firm be able to maintain the Bank’s condition?

You are required to compute Times Interest Earned Ratio post new 100% debt borrowing.

First, we need to develop EBIT, which shall be a reverse calculation.

Use the following data for calculation of times interest earned ratio

  • Time Interest Earned Ratio: 2.5Total Interest Expenses: 12000000

Calculation of EBIT

2.5  = EBIT / 12,000,000

EBIT  = 12,000,000 x 2.5

  • EBIT = 30,000,000

=30000000/16000000

  • Times Interest Earned Ratio= 1.88

Therefore, the firm would be required to reduce the loan amount and raise funds internally as the Bank will not accept the Times Interest Earned Ratio.

Volvo’s Times Interest Earned

We note from the above chart that Volvo’s Times Interest Earned has been steadily increasing over the years. It is a good situation due to the company’s increased capacity to pay the interests.

How to Use Times Interest Earned?

  • Analysts should consider a time series of the ratio. A single point ratio may not be an excellent measure as it may include one-time revenue or earnings. Companies with consistent earnings will have a consistent ratio over a while, thus indicating its better position to service debt.However, smaller companies and startups which do not have consistent earnings will have a variable ratio over time. Thus, lenders do not prefer to give loans to such companies. Hence, these companies have higher equity and raise money from private equity and venture capitalists.The banks and financial lenders often look at various financial ratios to determine the solvency of the Company and whether it will be able to service its debt before taking on more debt. The banks often look at the debt ratioDebt RatioThe debt ratio is the division of total debt liabilities to the company’s total assets. It represents a company’s ability to hold and be in a position to repay the debt if necessary on an urgent basis. Formula = total liabilities/total assetsread more, debt-equity ratioDebt-equity RatioThe debt to equity ratio is a representation of the company’s capital structure that determines the proportion of external liabilities to the shareholders’ equity. It helps the investors determine the organization’s leverage position and risk level. read more, and Times interest earned ratio.The negative ratio indicates that the Company is in serious financial trouble.

Limitations

Although a good measure of solvency, the ratio has its disadvantages. Let us have a look at the flaws and disadvantages of calculating the Times interest earned ratio:

  • Earnings Before Interest and taxEarnings Before Interest And TaxEarnings before interest and tax (EBIT) refers to the company’s operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization’s profit from business operations while excluding all taxes and costs of capital.read more used in the numerator is an accounting figure that may not represent enough cash generated by the Company. The ratio could be higher, but this does not indicate the Company has actual cash to pay the interest expense.The amount of interest expense used in the ratio’s denominator is again an accounting measurement. It may include a discount or premium on the sale of the bonds and may not include the actualInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more to be paid. To avoid such issues, it is advisable to use the interest rate on the face of the bonds.The ratio only considers the interest expenses. It does not account for principal paymentsPrincipal PaymentsThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan’s original amount is directly reduced.read more. The principal payments may be huge and lead the Company to insolvencyInsolvencyInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow.read more. Further, the Company may be bankrupt or have to refinance at the higher interest rate and unfavorable terms. Thus, while analyzing the solvency of the Company, other ratios like debt-equity and debt ratio should also be considered.

Times Interest Earned Ratio Video

This article has been a guide to Times Interest Earned Ratio and its meaning. Here we discuss how to use the Times Interest Earned ratio along with practical examples, advantages, and disadvantages. You may learn more about ratio analysis from the following articles –

  • Equity RatioImportance and uses of Ratio AnalysisInterpret ROCEReturn on Assets Formula