Another debt ratio that measures long-term solvency is the time interest earned (TIE). It’s also known as the interest cover ratio or fixed charge coverage. It is a measure of the amount of income that can be used for interest and debt service expenses (e.g. bonds and contractual debt). It is often used to assess whether a potential borrower can afford the additional debt.
The TIE can be used to determine how easy it is for a company to pay off its mortgages or long-term loans.
The solvency ratio is in some ways the time’s interest earned ratio. Because interest and debt service payments are typically made over a long period of time, they are often considered an ongoing fixed expense. Like most fixed expenses it is possible for a company to become bankrupt if they are unable or unable to pay the bills. This ratio could be referred to as a solvency ratio.
Calculation
The times’ interest earned ratio can be calculated by subtracting the income statement EBIT figure from the income statement from the interest expense (I).
Times interest earned = EBIT or Income Before Interest & Taxes/Interest Expense
The time’s interest earned ratio can be expressed in numbers rather than a percentage. The number indicates how often a company could pay interest with its income before taxes. Therefore, larger ratios are more advantageous than smaller ones. If the ratio is 4, then the company’s income will be sufficient to cover its interest expenses four times. The company’s income is four-fold higher than its annual interest expense.
The higher the number, the more the firm can pay its interest expense. A TIE lower than 1.0 means that the firm can’t pay its total interest expense. A high ratio could indicate that the company is either paying too much or not enough debt.
Example
Joe’s Excellent Computer Repair has applied for a loan and the bank would like to see financial statements. Creditors (e.g. banks and other lending institutions), assess whether the borrower can repay the loan principal and interest. The company’s ability to pay the loan, principal, and interest is indicated by the ratio of times interest earned. This statement shows that the company earned $50,000 before interest expenses and taxes. The total interest and debt service of the company for the year was $5,000. Therefore, the calculation would be:
$50,000 / $5,000 = Ten Times
Joe’s Excellent Computer Repair’s time’s interest earned ratio is 10, which means that the company’s annual income is 10x greater than the annual interest expense. This allows them to afford the new loan’s interest expense. Joe’s Excellent Computer Repair is not a high-risk company, so the bank will likely approve the loan application.
