What is the Times Interest Earned Ratio?
The Times Interest Earned (TIE) Ratio measures a company’s ability to service its interest expense obligations based on its current operating income.
Otherwise known as the interest coverage ratio, the TIE ratio helps measure the credit health of a borrower. As a general rule of thumb, the higher the times interest earned ratio, the more capable the company is at paying off its interest expense on time.
- What is the times interest earned (TIE) ratio used to measure?
- Why do borrowers and lenders pay close attention to the interest coverage ratio?
- Why would a borrower pay attention to the tax shield of interest expense?
- How would you interpret the TIE ratio to evaluate the credit health of a company?
Times Interest Earned Ratio Formula
The times interest earned ratio compares the operating income (EBIT) of a company relative to the amount of interest expense due on its debt obligations.
The formula for a company’s TIE ratio consists of dividing the company’s EBIT by the total interest expense on all debt securities.
The resulting ratio shows the number of times that a company could pay off its interest expense using its operating income. Alternatively, other variations of the TIE ratio can use EBITDA as opposed to EBIT in the numerator.
A higher times interest earned ratio suggests that the company has plenty of cash to service its interest payments and can continue to re-invest into its operations to generate consistent profits.
If a company has a high TIE ratio, this signifies its creditworthiness as a borrower and the capacity to withstand underperformance due to the ample cushion (to satisfy its debt obligations) provided by its cash flows.
On the other hand, a lower times interest earned ratio means that the company has less room for error and could be at risk of defaulting.
Companies with lower TIE ratios tend to have sub-par profit margins and/or have taken on more debt than their cash flows could handle.
While there aren’t necessarily strict parameters that apply to all companies, a TIE ratio above 2.0x is considered to be the minimum acceptable range, with 3.0x+ being preferred.
But once a company TIE ratio dips below 2.0x, it could be a cause for concern – especially if it’s well below the historical range, as this potentially points towards more significant issues.
Excel Template Download
Now, to see an example calculation of the times interest earned ratio, use the form below to download the file.
Times Interest Earned Ratio Calculation Example
In this exercise, we’ll be comparing the net income of a company with vs. without growing interest expense payments.
For Company A, we’ll be using the following listed assumptions:
- Operating Income (EBIT) in Year 0 = $100m
- Interest Expense in Year 0 = $25m
- EBIT Growth = $10m / Year
- Interest Expense Growth = $0m
Next, for Company B, we’ll be using the following listed assumptions:
- Operating Income (EBIT) in Year 0 = $80m
- Interest Expense in Year 0 = $25m
- EBIT Growth = – $10m / Year
- Interest Expense Growth = $5m / Year
Here, Company A is depicting an upside scenario where the operating profit is increasing while interest expense remains constant (i.e. straight-lined) throughout the projection period.
In contrast, Company B shows a downside scenario in which EBIT is falling by $10m annually while interest expense is increasing by $5m each year.
Given the decrease in EBIT, it’d be reasonable to assume that the TIE ratio of Company B is going to deteriorate over time as its interest obligations rise simultaneously with the drop-off in operating performance.
To calculate the times interest earned ratio, we simply take the operating income and divide it by the interest expense.
For example, Company A’s TIE ratio in Year 0 is $100m divided by $25m, which comes out to 4.0x.
See below for the completed output for both companies. We can see the TIE ratio for Company A increases from 4.0x to 6.0x by the end of Year 5. In contrast, for Company B, the TIE ratio declines from 3.2x to 0.6x in the same time horizon.
In closing, we can compare and see the different trajectories in the times interest earned ratio. For a lender deciding whether to provide financing to a potential borrower or not, as well as the terms associated with the lending package if applicable, Company A would be far more likely to receive favorable terms.