Times Interest Earned - Explained

What is Times Interest Earned?

What is Times Interest Earned?

Times interest earned (TIE) is used to measure if a company can pay up its debts or not. This calculates the number of times a company can pay up its interest charges before the deductions of tax. It is basically calculated by estimating the earnings of a company before its interest and tax rates (EBIT). This is then divided by the total interest to be paid on bonds and other contractual debt.

Back to: Accounting & Taxation

How does Times Interest Earned Work?

Times Interest Earned can also be referred to as an interest coverage ratio. Whenever a company fails to meet up with its debt obligations, then bankruptcy is inevitable. To avoid bankruptcy, a company needs to generate much earnings so as to meet up with its debts. These earnings are generated through stocks, debts, and others. All of these contribute to the TIE Ratio and referred to as Capitalization factors. These factors affect the TIE Ratio.

How to Calculate Times Interest Earned (TIE)

For example, a company with \$10 million in 4% debt to be paid and \$10 million in stocks. And the company saw a vital need to purchase equipment but with more capital. The cost of capital for more debt is an annual interest rate of 6% and shareholders expect an annual dividend payment of 8%, plus the appreciation in the stock price of the company. This is calculated as (4% X \$10 million) + (6% X \$10 million), or \$1 million annually. At the end, the company's Earnings Before Interest and Taxes calculation is \$3 million, which means that the TIE is 3, or three times the annual interest expense. This the amount paid on interest.

Factoring in Consistent Earnings

A company can raise capital through debt offerings rather than issuing stocks in as much as the company has a record of maintaining annual regular earnings. Companies that generate regular earnings are more attractive to lenders. Reasons because they will be able to pay interest on time. Hence, these companies will have more debts. A good example is the Utility company, they will be able to raise 60% or more of their capital from issuing debt. On the other hand, businesses that have irregular annual earnings try to use stock to raise capital.

Related Topics