Times interest earned ratio determines the company’s ability to make interest payments on the money it has taken as a loan, that is, this is the company’s solvency ratio. The interest coverage ratio, as you can also call it, computes how many times pre-tax profits outweigh the interest portion of the loan repayment or the number of times one could pay interest from pre-tax profits. If a particular business is engaged exclusively in the main activity and has no other expenses/income, then its EBIT will be equal to the operating profit.
You can see the formula for computing this ratio above. Let’s use it to find the interest coverage ratio for Leaf Company. The business owner wants to buy new equipment and for this, she needs to apply for a loan. Not surprisingly, the bank looks at Leaf Company’s financial statements and determines its solvency.
From the Income Statement, we can tell that the company made $185,000 of EBIT. As of the last year, she had paid $22,000 in interest. To calculate the ratio we simply need to divide $185,000 by $22,000. This would give us a ratio of 8.41. Read on to find out what this ratio means for the bank.
The interest coverage ratio shows the possible decrease in the ability of the operating profit of the enterprise to service interest payments. It helps to assess the level of protection of lenders from non-payment of debts by the borrower. A normal value is considered to be between 3 and 4. If the ratio becomes less than 1, it means that the business is not generating sufficient cash flow from operating income to make these payments.
For a complete analysis of the company’s times interest earned ratio, it is necessary to take into account not only the particular values of the ratio in a certain year but also look at its dynamics. Ideally, this ratio needs to be measured over the entire period when the company had debt service payments. Moreover, for an objective analysis of the company’s health, it is important to calculate other relative financial ratios.
It is a good sign when the value of the company’s interest coverage ratio grows or remains at a sufficiently high level. For example, analyzing this ratio on a quarterly basis over the past several years will allow an investor to see whether the low current interest coverage ratio is getting better or worsening, or if the high current value is stable.
Investors should be wary when the value of this financial analysis tool is going down over a certain span of time, as this indicates that the company is having a harder time meeting its interest payment obligations and may not be able to make them in the future. The ratio can also be used in making an investment decision by allowing the investors to put different companies side by side and see how well they are doing in terms so the ability to at least pay the interest on their debts.