A company’s times interest ratio indicates how well it can pay its debts while still investing in itself for growth. A higher ratio suggests to investors that an investment in the company is relatively low risk. Lenders also use times interest expense ratio when evaluating credit decisions. A company’s executives may compare its times interest ratio to similar companies in the same business to see how well they are doing.
Ask a financial advisor for assistance evaluating the strength of companies you might like to include in your portfolio.
Times Interest Earned Ratio Definition
The times interest ratio, also known as the interest coverage ratio, is a measure of a company’s ability to pay its debts. A higher ratio indicates less risk to investors and lenders, while a lower times interest ratio suggests that the company may be generating insufficient earnings to pay its debts while also re-investing in itself.
Times interest earned is calculated by dividing earnings before interest and taxes (EBIT) by the total amount owed on the company’s debt.
For example, if a business earns $50,000 in EBIT annually and it pays $20,000 in interest every year on its debts, figuring the times interest earned ratio requires dividing $50,000 by $20,000. The result, 2.5, is the times interest earned ratio.
What a High Times Interest Earned Ratio Means
The times interest earned ratio is a popular measure of a company’s financial footing. It’s easy to calculate and generates a single number that is simple to understand.
A times interest ratio of 3 or better is better considered a positive indicator of a company’s health. A times interest earned ratio of 2.5 is acceptable. If the ratio is under 2, it may be a cause for concern among investors or lenders and may indicate the company is in danger of having to file for bankruptcy protection.
A times interest earned ratio can also be too high. It can suggest that the company is under-leveraged, and could achieve faster growth by using debt to expand its operations or markets more rapidly.
How Companies and Investors Use Times Interest Earned Ratio
Investors and lenders aren’t the only ones who use the times interest ratio. Companies also employ it internally to guide strategy. For instance, if a company has a low times interest earned ratio, it can probably expect have difficulty arranging a loan.
Companies also use times interest earned ratios to compare themselves to other firms. However, the times interest earned ratio is affected by the industry or sector, so companies will generally compare themselves with companies in the same business. The times interest earned ratio is also less useful for small companies that don’t carry a lot of debt, and for companies that are losing money.
Investors may also be cool to debt securities or stock sales by companies with low times interest earned ratios. Businesses contemplating issuing bonds or making public stock offerings often consider their times interest earned ratio to help them decide how successful the initiative will be.
Times interest earned ratio does have limitations. For one thing, it may not account for a large balloon payment of principal that could be due on a business’s debt in the near future. Also, businesses that rely on extending credit to buyers of their products or services may have a low times interest earned ratio while still maintaining good financial health.
If a company has a low times interest earned ratio, it can improve this measure by increasing earnings or by paying off debt. Cost-cutting can be an effective way to increase earnings, even if sales are not expanding. Refinancing existing debt can also reduce debt service payments and boost the times interest earned ratio.
The Bottom Line
The times interest earned ratio is an accounting measure used to determine a company’s financial health. It’s calculated by dividing net income before interest and taxes by the amount of interest payments due. A times interest earned ratio of more than 3 indicates that the company can meet its debt obligations while still being able to reinvest in itself for growth. Investors and lenders may look at the times interest earned ratio when deciding whether to purchase equity or extend credit to a company.
- A financial advisor understands how to apply times interest earnings and other benchmarks to prospective investments to construct a sound portfolio suited to your traits as an investor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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