The Times Interest Earned ratio (TIE) is a measurement used by companies and lenders that determines a company’s capability to pay off their debt, considering their annual income at the time of the calculation.
Companies use the ratio to weigh the risks of taking on more debt, while lenders use the ratio to determine if the company to whom they are considering issuing a loan will be a good investment.
The bottom line is that a company’s TIE reveals whether it can pay its debts. You might also see the times interest earned ratio called the interest coverage ratio or the fixed charge coverage.
No matter the terminology, the TIE is a debt ratio that allows the company and lenders alike to gauge how quickly or easily it will be to pay off long term or short-term debts accrued from loans, mortgages, bonds, or contracts.
Because most debt or interest payments on the debt take years to pay off, you might view them as static expenditures. In that case, interest payments are fixed fees that a company must pay regularly, and an inability to do so would result in bankruptcy. Therefore, the TIE is, in part, a measure of a company’s solvency.
How to Calculate and Use the TIE
The formula to calculate the times interest earned ratio is:
Earnings Before Interest and Taxes
Interest Expenses
Earnings Before Interest and Taxes (EBIT) is basically a company’s revenue before deducting expenses due to income tax or debt interest payments. You might also see it referred to as a company’s operating income. Interest Expenses are the payments the company must make on their debts.
Therefore, the TIE ratio is a simple division of two whole numbers that should yield a number greater than 1 to indicate that a company can pay off its debts.
If the number is less than one, then the company cannot pay off their debts and will surely head towards bankruptcy, to say nothing of their apparent incapacity to take on more debt by asking for a loan.
Of course, the TIE ratio is not just concerned with whether a company can pay off its debt without going bankrupt, but rather how free from debt restrictions a company is so that they have money both to pay off their debts and grow by expanding their own investments.
It is also worth noting that interest expenses are not just from debt. They can also be from issuing stock.
If the TIE ratio is 1, then the company will break even after debt expenses, but if the ratio is 2, they can pay off their debt twice over.
The bigger the TIE ratio number, the more money the company has left over after paying off their interest expenses.
Therefore, if the company has a TIE ratio of 10, they can clearly take on more debt for different endeavors, and banks or other lenders will view them as worthy investments and vie for their business.
Example of When and How to Use the TIE
SMD Utilities Company is a successful and stable company, providing essential services that render consistent earnings. Currently, they have $20 million of debt with an annual interest rate of 5%.
They would like to take on more debt to expand their services to a more extensive customer base.
Both the company and potential lenders or investors must calculate the TIE ratio before deciding if SMD can take on more debt so that they can expand their business.
They have an EBIT of $30 million. Their TIE is their EBIT divided by their annual interest expenses. Their annual interest expenses are 5% of $20 million, or $1 million.
Therefore, their TIE is $30 million/ $1 million, which yields a score of 30. This means that they can afford to pay off their debt 30 times over, which means they have more than enough capital to take on more debt.