Time Interest Earned Ratio Analysis Explained
Businesses are often started by taking loans, unless you’re already rich, of course.
As a company grows, it repays old loans and takes on new ones, and these new loans are supposed to help the company grow even further.
Now, while improved productivity can help you get more ROI, it’s not the only thing to take a look at.
There’s no shame in taking a loan; it’s necessary for those of us who may not be able to pay for a running business out of the pocket. It is kinda important, though, to pay it back in time, meaning that your business needs to run.
Let’s take an example of a baker, who initially borrows some amount of money to open up a bakery.
Once the baker earns enough profits, he can repay the loan.
Later on, he again needs to take a loan to get a larger variety of ingredients, hire a few helping hands, and expand the store to make space for an increasing number of customers.
Clearly, this loan will be greater than the first one, but the baker predicts that his sales will get better with a bigger loan.
With business booming, as usual, the bank will easily lend him more money, and he will repay the loan when the time comes.
…but is his business really booming?
It’s not that easy to get another, larger loan. It involves some math. Shocking, I know.
A bunch of things needs to be calculated and compared before the baker can borrow any more.
To predict whether the baker can repay the new loan, he would need to crunch some numbers― find out what his profits are, how much of those were used to pay back for the first loan, and whether he’ll be able to earn enough to pay back the new loan.
Then, the bank would compare these amounts with similar businesses. The bank will agree to give out another loan only if the numbers look good.
Now, what exactly are those numbers?
The ability of a company or business to pay off a long-term debt is called solvency.
Banks and financial lenders often use a variety of financial ratios to determine a company’s solvency, and one of those ratios is called the time’s interest earned (TIE) ratio.
It is important for a lender to know whether the business they are loaning to (in this case, the baker) will be able to earn enough to be able to pay them back.
Otherwise, money lent is money given away, and we all know banks don’t just give away money.
WHAT IS THE TIMES INTEREST EARNED RATIO?
It’s easy to find out if the baker can repay his future loans.
You can calculate the ratios differently, like using the debt ratio, the debt-equity ratio, and the ratio that we are discussing right now, the time’s interest earned ratio.
Let’s get a bit technical here.
The Times Interest Earned (TIE) ratio, also called the interest coverage ratio, measures the proportionate amount of income that can be used to cover interest expenses in the future.
We can find out if the baker will be able to cover his interest expenses using this.
It is calculated by dividing a company’s operating income (called EBIT―earnings before interest and taxes) with its interest expenses.
Thankfully, the formula is pretty simple:
Both of the above values can be found in the income statement of the company.
This formula is not only for bakers! If you have a business which relies on loans to grow, as many businesses do, then you too can use it to find out if you’re going to be behind on your interest payments. Any company which earns a relatively stable income can use this tool.
A LOOK AT THE ANALYSIS
The Times Interest Earned ratio is given in numbers instead of as a percentage. It tells us how many times a company could pay the interest with what it earns.
All of this is before income tax (watch out, this can be a problem).
EBIT is used in the formula because you’d want that company should be able to pay off all of its interest expenses before having to pay for any income taxes.
Since interest repayments are done on a long-term basis, the Times Interest Earned ratio is seen as a measure of a company’s solvency.
We analyze the ratio in the context of a company’s industry. Financial analysts also use other solvency ratios.
Our baker from earlier would be analyzed and compared with other small bakers or with similar businesses before he can apply for a loan.
Lending bodies would obviously prefer firms with a higher TIE ratio since it shows that they are easily able to pay off their interests and won’t be in danger of going bankrupt.
A lower ratio would point out that the company might not be able to pay back its debts in due time, so it would be difficult for that company to get a loan.
Generally, your firm will need to have a TIE ratio of at least 2.5 to apply for a loan. If your businesses have a times interest ratio of less than 1, you will not be able to repay the debt.
You’d also need to consider a time series of the TIE ratio, meaning that the TIE ratio is taken several times over a certain amount of time (let’s say every three months for two years).
A single ratio might not be accurate as it might include revenue or earnings of only a small period.
Businesses with consistent earnings will have a consistent ratio during those two years, suggesting a better position to repay loans.
Smaller businesses which don’t have consistent earnings will not have much stability in the TIE ratio over a long period (sounds like trouble for a local baking business, right?).
Their TIE ratios will vary a lot.
This is why lenders don’t prefer to give loans to such businesses.
The baker would need to earn a steady and somewhat predictable income in order to take a loan from a lender to expand his bakery business.
SOME EXAMPLES TO HELP YOU GET TO THE NITTY GRITTIES
Alright, here we go, time for some math. You’re not alone.
It’s always nice to have someone to take you through the steps when using a new formula, isn’t it?
Thankfully, it is quite easy to find the TIE ratio.
Let’s look at a couple of examples of how the Times Interest Earned ratio is calculated and used.
Calculation of the Times Interest Earned ratio of the baker for his new loan.
Our baker wants to apply for a new loan, right?
Now, before the bank can consider him for a one, they ask for his financial statements.
So he takes out his financial statements from the last year and gives it to the bank.
Here, we’ll imagine simple values so it is easy to calculate. His income statement shows that he earned $32,000 of income last year before interest expense and income taxes.
The baker’s total interest expense for last year was $8,000. His TIE ratio is calculated as:
As we can clearly see, the TIE ratio is 4, meaning that the baker’s earnings were 4 times as much as his annual interest expenses and that yes, his business is indeed booming for a newbie.
The baker was easily able to cover for his interest expenses and will likely be able to do so again, given that his earnings remain steady.
This suggests that the baker’s business has less risk for now, so the bank will likely accept his loan.
This is all fine and dandy… until the bank realizes that during the last five years, a whole lot of bakers across the country have taken loans and some of them aren’t doing so well.
Remember when we said that the bank compares the numbers among similar businesses? Well, that is what we’ll explore in the next example.
Calculation and comparison of two different bakeries’ Times Interest Earned ratios.
The bank takes a look at our baker (let’s call him Baker A) and several other bakers who have been working for around the same time as he has.
For simplicity, we’ll only use one other baker, Baker B, for comparison.
We’ll assume that the TIE ratio of Baker B is the average TIE ratio of those several similar bakers.
Earlier we also learned that the TIE ratio is often taken more than once so that we can see if the income is steady enough for a business to be considered for further loans.
So, we’ll also compare the TIE ratios of Bakers A and B over two years.
This part requires a little more attention since there we are computing for and comparing four different ratios.
|Income Before Interest and Taxes||$29,600||$32,000|
|Times Interest Earned Ratio||3.7||4|
|Income Before Interest and Taxes||$28,800||$30,000|
|Times Interest Earned Ratio||3.6||2.86|
You can take a quick glance and see that while the individual Baker A’s TIE ratio increases by 0.3, the average TIE ratio represented by Baker B actually decreases by 0.8.
You will notice that times interest earned ratio of 2.86 is close to 2.5, which, as we learned earlier, is the minimum amount required to take a loan in the first place.
This tells the bank that the general market trend is actually going downwards.
Baker B had an increase in earnings as well as growing interest expenses. However, it resulted in an overall decrease in profits according to the TIE ratio.
Baker A’s profits got larger as well. However, his interest expenses remained the same. The TIE ratio also increased, but only a little.
This could make the bank reluctant to lend to Baker A, as the data suggests that average baker finds it increasingly difficult to pay back interest on higher loans.
It looks like our baker may have to borrow from a different source for the time being.
Here are a few more examples that can help you to understand the concept better.
ADVANTAGES AND DISADVANTAGES OF TIME INTEREST EARNED RATIO
The Times Interest Earned ratio is, after all, one of many formulas which are used to determine the financial status of a firm.
It has many benefits and can be useful for a range of companies.
Did you know, for instance, that Volvo’s TIE is increasing every year?
But it does have its own drawbacks. If you thought the TIE ratio was too good to be true, unfortunately, you were right.
You will be glad to know, however, that the advantages slightly outnumber the disadvantages.
First, let’s look at what the TIE ratio does well.
- The ratio can indicate the company’s long-term financial success, called solvency. It also gives us a peek at the future of the business. A high or increasing ratio means that the company is doing well and will likely keep growing.
- The formula is super easy to remember! Calculating TIE ratio is a breeze―just plug in the two values from your income statement, and there you have it. For a small business owner like the baker, it is a free and quick tool which doesn’t require a professional degree.
- TIE ratio shows us not only the future but also the present situation. The Times Interest Earned ratio tells us the current financial position of the business. In the first example, the baker could determine that he was definitely earning enough to pay off his debts and that with the same amount of interest expenses, his profit was increasing. The TIE ratio can be used to compare between two or more firms. As we saw in the second example, the TIE ratios were an easy tool to find out how the baker was doing in his field as compared to others.
- If the ratio is negative or decreases over time, then the business owner knows that they are in trouble. Thankfully, because the calculation process is fast, action can be taken immediately to curb losses. The baker can analyze the TIE ratio and found out why the baking market is not doing so great. He can focus on what is making his business grow and what common mistakes to avoid.
- The first problem lies with the first value we put in. The earnings before Interest and tax (EBIT) used in the numerator is an accounting calculation that may not necessarily represent the total cash generated by the company. Therefore, the TIE ratio could be high, but a business might not really have actual cash to pay the interest expense. And vice versa―the ratio could be low, even though the business owner has quite a lot of cash. This is something the baker may have to be very careful with.
- The second problem lies with… any guesses? It’s the denominator, i.e., the second value. The amount of interest expense which we see in the denominator is yet another accounting calculation. It can include discounts or premium on the sale of bonds. So, it may or may not show the true amount of interest expense which we need to pay. In such cases, you’d be better off referring to the interest rate mentioned on the face of the bonds.
- And for the final problem, the one which some of you may have been wondering about already. It lies with the fact that we are only looking at the interest bit and not the entire amount borrowed. The TIE ratio does not account for the total loan taken, the principal amount, but only calculates for the interest on top of it. The basic loan, without the interest, can be gigantic. It may lead the company to bankruptcy. If not that, then the business owner could be forced to refinance at a higher interest rate and on tougher terms than he is currently on.
This is the reason why the bank may not want to loan a higher amount to the baker, even if he is seemingly earning more and more each year.
So, when you’re trying to find out the financial standing of your firm, you would also want to take into account the other solvency ratios mentioned earlier, like the debt-equity ratio and debt ratio.
It would not be wise to only look at the Times Interest Earned ratio and ignore the other ones.
JUST THAT LITTLE EXTRA INFORMATION TO HELP YOU TAKE THE RIGHT DECISION
Congratulations for making this far down the article! If you scrolled past everything above to only be congratulated here, then I’d advise you to head back up.
A bunch of important things is covered, trust me. I get that by now you must be a little tired.
Don’t worry; only a little bit is left. It might also help you out.
It can be difficult for many small businesses to pay back loans, even though they are a cheap source of finance. It’s mostly because the tax can be deducted from the cost of interest in most jurisdictions.
That is not the case with dividend payments.
But, interest costs have to be paid back, whereas dividend payouts can depend upon the intent of the management.
So, the debt level should not be higher than the point which would lead your organization to incredibly high financial risk.
If you’re running a smaller scale business or thinking of running one, you might want to consider raising money from venture capitalists and private equity (i.e., stock).
Many startup companies, for example, prefer to finance equity through venture capital institutions, rather than by taking loans. This is because of the high level of risk involved.
Companies like this tend to have very high ratios of interest coverage, which can be misleading like we saw with the baker.
Now, once your business can show that it is generating reliable earnings, you can raise capital through debt offerings and move away from issuing common stock.
That takes time, though so you’ll have to be patient.
The Times Interest Earned ratio (TIE) measures a firm’s solvency and whether it can make enough money to pay back any borrowings.
The ratio gives us the number of times the profits can cover just the interest expenses.
A higher ratio is since it shows that the company is doing well. A ratio of more than 2 or 2.5 is favorable.
Generally, companies should aim to maintain interest coverage of at least 2 to 2.5 times.
A lower TIE ratio suggests that there would be a lot of fluctuations in profits. This could lead to delays in the payment of interest.
Lenders don’t usually rely on the TIE ratio alone, and the business owner shouldn’t either. You need to consider other ratios like debt ratio, debt-equity ratio before taking a loan.
You should take into account industry and economic factors, as well as other internal factors.