1. Definition
Time Interest Earned shows how many times the annual interest expenses are covered by the net operating income before interest and tax of the company. It is a long-term solvency ratio that measures the ability of a company to pay its interest charges as they become due. Times interest earned ratio is known by various names such as debt service ratio, fixed charges cover ratio and Interest coverage ratio. The retio is expressed in times.
Times interest earned = operating income (income before tax and interest) / Interest expense
Income before tax and interest (i.e., net operating income) and interest expense figures are available from the income statement.
2. Example A
A creditor has extracted the following data from the income statement of PQR and requests you to compute and explain the times interest earned ratio for him.
| Net operating income | 2570 |
|---|---|
| Interest expense | 320 |
| Net income before tax and interest | 2250 |
| Income tax (40%) | 500 |
| Net income | 1750 |
Compute times interest earned of the company is
Times interest earned = operating income (income before tax and interest) / Interest expense
= 2570 / 320
= 8.03
It means that the interest expenses of the company are 8.03 times covered by its net operating income. Times interest earned ratio is very important from the creditors view point. A high ratio ensures a periodical interest income for lenders. The companies with weak ratio may have to face difficulties in raising funds for their operations. Generally, a ratio of 2 or higher is considered adequate to protect the creditors’s interest in the firm A ratio of less than 1 means the company is likely to have problems in paying interest on its borrowings. A very high times interest ratio may be the result of the fact that the company is unnecessarily careful about its debts and it not taking full advantages of the debt facilities.