What is Times Interest Earned ratio ?
Times Interest Earned ratio is used to measure the ability of a company to pay its interest expense
based on its EBIT. It is also known as Interest Coverage ratio.
How is the Times Interest Earned ratio calculated ?
The Times Interest Earned Ratio is calculated using the formula
= EBIT / Interest Expense
EBIT is Earnings before Interest and Tax. EBIT can be calculated in the following two ways as follows :
a.EBIT = Total Revenue – Cost of goods sold – Operating expenses
b.EBIT = Net Income + Income Tax Expense + Interest Expense
How is the Times Interest Earned ratio interpreted ?
The ratio can be interpreted as the number of times the company could pay its Interest Expense with its present EBIT.
The Times Interest ratio should ideally be greater than 1.0. This implies that the company has sufficient Earnings to pay its debt obligations in the form of Interest Expense.
If the ratio is lower than 1 it means that the company is not generating enough earnings to pay its Interest Expense.
The higher the Times Interest Earned Ratio implies lesser the likelihood of the company in defaulting in its Interest payments. In case a company has a low Times Interest Earned Ratio the risk of the company being unable to pay its Interest expense increases.
A high Times Interest ratio implies that the company will be able to pay its fixed Interest expense without defaulting. This builds the confidence of investors in the company and attracts better sources of Investment. On the other hand, it could also imply that the company has enough and more funds that are idle and can be invested in revenue generating avenues.
Sample question with solution
Richsons co. has EBIT of $ 400,000 and Interest Expense of $ 80,000. Calculate the Times Interest Earned ratio.
As per the information provided in the question
EBIT = $ 400,000 ; Interest Expense = $ 80,000 ;
The Times Interest Earned ratio is
= $ 400,000 / $ 80,000 = 5
The Times Interest Earned ratio = 5 times.
This implies that the company has 5 times the amount of Earnings required to pay its Interest expense.