The times interest earned ratio measures the ability of an organization to pay its debt obligations. The ratio is commonly used by lenders to ascertain whether a prospective borrower can afford to take on any additional debt. The ratio is calculated by comparing the earnings of a business that are available for use in paying down the interest expense on debt, divided by the amount of interest expense. The formula is:
Earnings before interest and taxes ÷ Interest expense
For example, a business has net income of $100,000, income taxes of $20,000, and interest expense of $40,000. Based on this information, its times interest earned ratio is 4:1, which is calculated as:
($100,000 Net income + $20,000 Income taxes + $40,000 Interest expense) ÷ $40,000 Interest expense
A ratio of less than one indicates that a business may not be in a position to pay its interest obligations, and so is more likely to default on its debt. A much higher ratio is a strong indicator that the ability to service debt is not a problem for a borrower.
There are a number of flaws associated with this ratio, which are:
- The EBIT figure noted in the numerator of the formula is an accounting calculation that does not necessarily relate to the amount of cash generated. Thus, the ratio could be outstanding, but a business may not actually have any cash with which to pay its interest charges. The reverse situation can also be true, where the ratio is quite low, even though a borrower actually has significant cash flows.
- The amount of interest expense appearing in the denominator of the formula is an accounting calculation that may incorporate a discount or premium on the sale of bonds, and so does not equate to the actual amount of interest expense that must be paid. In these cases, it is better to use the interest rate stated on the face of the bonds.
- The ratio does not take account of any looming principal paydown, which could be large enough to bring about the bankruptcy of the borrower, or at least force it to refinance at a higher rate of interest, and with more severe loan covenants than it currently has.
Also, a variation on the times interest earned ratio is to also deduct depreciation and amortization from the EBIT figure in the numerator. However, depreciation and amortization indirectly relate to a business' need to buy fixed assets and intangible assets on a long-term basis, and so may not represent funds that are available for the payment of interest expense.
Times interest earned is also known as the interest coverage ratio.