A company can raise capital in one of two ways: using debt or equity. Raising capital using both means has costs associated with it, namely the cost of debt and the cost of equity. In addition to that, shareholders have expectations for dividends and share price appreciation. The finance department must balance the various factors before making a decision on how to raise capital.
For a company servicing existing debt, the times interest ratio is an indicator of how much more debt the company can take on without making a dent in the dividends paid and shareholder value.
Imagine a company with an EBITDA of $2M servicing a debt of $10M at 10% cost. The annual interest expense is $1M. The times interest earned ratio is 2. The company needs additional capital of $20M. Taking debt at the same cost of 10%, the TIE ratio becomes 0.66 with the same EBITDA. This means that the company will not be able to service the loan at all. The company will have to find another source for capital or avail debt at a significantly lower cost of debt.
When the times interest ratio is less than 1, it means the interest expense is more than the company’s earnings before tax. When the TIE ratio is 1, the company can barely repay the debt without any cash remaining for tax and other expenses. The company’s position is deemed better as the number climbs above 1. It’s better to have a TIE ratio as large as possible.
