What Does a High Times Interest Earned Ratio Signify for a Company’s Future?

The times interest earned ratio is a common solvency ratio used by both creditors and investors. Often referred to as the interest coverage ratio, it depicts a company’s ability to cover the interest owed on its debt obligations. It’s expressed as income before interest and taxes divided by interest expense.

Key Takeaways

• The times interest earned ratio is a solvency metric that evaluates how well a company can cover its debt obligations.
• It’s calculated by dividing a company’s EBIT by its interest expense although variations change both of these figures.
• A high times interest earned ratio typically means that a company has stronger performance and is less risky.
• A high calculation could also mean that a company isn’t prioritizing growth and may not be a strong long-term investment.
• Several limitations should be considered when using the times interest earned ratio.

What Is the Times Interest Earned Ratio?

The ratio is stated as a number rather than a percentage and the figures that are necessary to calculate the times interest earned are found easily on a company’s income statement. A ratio of 5 means that the business can meet the total interest payments owed on its outstanding, long-term debt five times over or that the business’ income is five times higher than the interest expenses owed for the year.

Times Interest Earned Ratio Formula

The times interest earned ratio is a company’s earnings before interest and taxes divided by a company’s interest payable on bond and debt obligations:

Earnings Before Interest and Taxes / Interest Expense = times interest earned ratio

Example

Assume a company has $5 million in outstanding debt at a rate of 5% and EBIT of $1 million. The company is expecting to be assessed $250,000 ($5 million * 5%) of debt based on its debt and rate. The company’s high times earned ratio is 4 ($1 million / $250,000).

What a High Times Interest Earned Ratio Can Tell You

A higher times interest earned ratio is favorable because it means that the company presents less of a risk to investors and creditors in terms of solvency. An organization that has a times interest earned ratio greater than 2.5 is considered an acceptable risk. Companies that have a times interest earned ratio of less than 2.5 are considered a much higher risk for bankruptcy or default.

A times interest earned ratio can also be inefficiently high. A business can choose to not use excess income for reinvestment in the company through expansion or new projects but rather pay down debt obligations. A company with a high times interest earned ratio may lose favor with long-term investors for this reason.

Time Series

Consider calculating the ratio several times over a specified period to determine whether it’s high. You’ll better understand whether a high calculation is standard or a one-time fluke if you analyze a company’s results over time.

Limitations of the Times Interest Earned Ratio

A higher times interest earned ratio is favorable but it doesn’t necessarily mean that a company is managing its debt repayments or its financial leverage most efficiently.

The times interest earned ratio is highly dependent on industry metrics. Every sector is financed differently and has varying capital requirements. A company may seem to have a high calculation but it might have the lowest calculation compared to similar companies in the same industry.

The ratio is also dependent on stable earnings. It will distort the realistic operations of the business if the company doesn’t earn consistent revenue or it experiences an unusual period of activity. This is also true for seasonal companies that may generate unfairly low calculations during slower seasons.

There’s also a risk that the company isn’t generating enough cash flow to pay its debts because cash isn’t considered when calculating EBIT. The times interest earned ratio will fail to detect that the company may not have enough money on hand to pay interest if a substantial portion of a company’s revenue is credit sales to be paid in future installments even if the company is recording enough revenue.

EBITDA

Consider calculating the times interest earned ratio using EBITDA instead of EBIT to get a better sense of cash flow. This variation is more closely tied to actual cash received in a given period.

The times interest earned ratio is also somewhat biased towards larger, more established companies in safer sectors due to credit terms and interest rates. Imagine two companies that earn the same amount of revenue and carry the same amount of debt. One company’s debt may be assessed at a rate twice as high, however, because it’s younger and it’s in a riskier industry. One company’s ratio is more favorable even though the composition of both companies is the same in this case.

The times interest earned ratio doesn’t include principal payments, either. A company might have more than enough revenue to cover interest payments but it may face principal obligations coming due that it won’t be able to pay.

What Is the Times Interest Earned Ratio?

Times interest earned ratio is a solvency metric that evaluates whether a company is earning enough money to pay its debt. It specifically compares the income a company makes before interest and taxes against what interest expense it must pay on its debt obligations.

What Is a Good High or Low Times Interest Earned Ratio?

The times interest earned ratio is usually different across industries but it’s generally best to have a times interest earned ratio that demonstrates that the company can earn multiple times its annual debt obligation. It’s often cited that a company should have a times interest earned ratio of at least 2.5.

How Can You Find the Times Interest Earned Ratio?

The times interest earned ratio is calculated by dividing a company’s EBIT by the company’s annual debt obligations.

The Bottom Line

The times interest earned ratio is a measurement of a company’s solvency. A higher calculation is often better but high ratios may also be an indicator that a company isn’t being efficient or prioritizing business growth.

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