Times interest earned (TIE) ratio is a financial ratio that signals the company’s ability to pay off its debt.
Also called the interest coverage ratio, it’s the ratio of EBITDA (earnings before interest, taxes, depreciation, and amortization) to the company’s interest expense.
It is helpful to calculate because debt can turn out to be an Achilles heel for businesses. Even in the event of dilution of a company, debts are the first obligations serviced before meeting the obligations to other stakeholders. Shareholders are serviced only at the end. Potential investors and existing shareholders must be conscious of the company’s debt burden.
The formula for the times interest earned ratio is:
In simple terms, the TIE ratio is the number of times the current interest expense can be paid off by the current EBITDA. You can find the interest expense and calculate the company’s pre-tax income from the parameters available in the income statement.
Implications of the TIE ratio
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.