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What Is the Times Interest Earned (TIE) Ratio?
The times interest earned (TIE) ratio is a solvency ratio that determines how well a company can pay the interest on its business debts. It is a measure of a company’s ability to meet its debt obligations based on its current income. The formula for a company’s TIE number is earnings before interest and taxes (EBIT) divided by the total interest payable on bonds and other debt. The result is a number that shows how many times a company could cover its interest charges with its pretax earnings. TIE is also referred to as the interest coverage ratio.
Key Takeaways
- A company’s times interest earned ratio is a solvency ratio that indicates its ability to pay its debts.
- The formula for TIE is calculated as earnings before interest and taxes divided by total interest payable on debt.
- The higher the TIE ratio, the better, as it shows how often a company can pay its debt charges with its current earnings.
- A better TIE number means a company has enough cash after paying its debts to continue to invest in the business.
Investopedia / Julie Bang
Formula and Calculation of the Times Interest Earned (TIE) Ratio
Assume, for example, that XYZ Company has $10 million in 4% debt outstanding and $10 million in common stock. The company needs to raise more capital to purchase equipment. The cost of capital for issuing more debt is an annual interest rate of 6%. The company’s shareholders expect an annual dividend payment of 8% plus growth in the stock price of XYZ.
The business decides to issue $10 million in additional debt. Its total annual interest expense will be (4% X $10 million) + (6% X $10 million), or $1 million annually. The company’s EBIT is $3 million.
This means that the TIE ratio for XYZ Company is 3, or three times the annual interest expense.
What the Times Interest Earned (TIE) Ratio Can Tell You
Obviously, no company needs to cover its debts several times over in order to survive. However, the TIE ratio is an indication of a company’s relative freedom from the constraints of debt. Generating enough cash flow to continue to invest in the business is better than merely having enough money to stave off bankruptcy.
A company’s capitalization is the amount of money it has raised by issuing stock or debt, and those choices impact its TIE ratio. Businesses consider the cost of capital for stock and debt and use that cost to make decisions.
Companies that have consistent earnings, like utilities, tend to borrow more because they are good credit risks.
Special Considerations
As a rule, companies that generate consistent annual earnings are likely to carry more debt as a percentage of total capitalization. If a lender sees a history of generating consistent earnings, the firm will be considered a better credit risk.
Utility companies, for example, generate consistent earnings. Their product is not an optional expense for consumers or businesses. Some utility companies raise a considerable percentage of their capital by issuing debt.
Startup firms and businesses that have inconsistent earnings, on the other hand, raise most or all of the capital they use by issuing stock. Once a company establishes a track record of producing reliable earnings, it may begin raising capital through debt offerings as well.
What Does a Times Interest Earned Ratio of 0.90 to 1 Mean?
The times interest earned ratio shows how many times a company can pay off its debt charges with its earnings. If a company has a ratio between 0.90 and 1, it means that its earnings are not able to pay off its debt and that its earnings are less than its interest expenses.
Is Times Interest Earned a Profitability Ratio?
No, times interest earned is not a profitability ratio. It is a solvency ratio. The ratio does not seek to determine how profitable a company is but rather its capability to pay off its debt and remain financially solvent. If a company can no longer make interest payments on its debt, it is most likely not solvent.
How Can a Company Improve Its Times Interest Earned Ratio?
To improve its times interest earned ratio, a company can increase earnings, reduce expenses, pay off debt, and refinance current debt at lower rates.
The Bottom Line
The times interest earned ratio looks at how well a company can furnish its debt with its earnings. It is one of many ratios that help investors and analysts evaluate the financial health of a company. The higher the ratio, the better, as it indicates how many times a company could pay off its debt with its earnings.