The times interest earned ratio, also known as the interest coverage ratio, is a measure of a company's ability to pay its debts while still investing in itself for growth. It is calculated by dividing earnings before interest and taxes (EBIT) by the total amount owed on the company's debt. A higher ratio suggests to investors that an investment in the company is relatively low risk, while a lower ratio may indicate the company is generating insufficient earnings to pay its debts.
What is a good times interest earned ratio for a company?
A times interest earned ratio of 3 or better is generally considered a positive indicator of a company's health, while a ratio of 5 is acceptable. If the ratio is below 2, it may be a cause for concern among investors or lenders and may indicate the company is in danger of bankruptcy. However, a times interest earned ratio can also be too high, suggesting that the company is under-leveraged and could achieve faster growth by using debt to expand its operations or markets more rapidly.
How Companies and Investors Use Times Interest Earned Ratio
Investors, lenders, and companies themselves use the times interest earned ratio to evaluate the financial health and risk of a company. Investors and lenders look at the ratio to assess the company's ability to meet its debt obligations and determine the level of risk involved in investing or lending to the company. Companies use the ratio to guide their financial strategies and compare themselves to other firms in the same industry to assess their performance.
However, it's important to note that the times interest earned ratio is affected by the industry or sector, so companies will generally compare themselves with similar companies in the same business. The ratio is also less useful for small companies with low levels of debt and for companies that are losing money.
Limitations of Times Interest Earned Ratio
While the times interest earned ratio is a useful measure of a company's financial health, it does have limitations. It may not account for a large balloon payment of principal that could be due on a business's debt in the near future. It also may not reflect the financial health of companies that rely on extending credit to buyers of their products or services.
If a company has a low times interest earned ratio, there are ways to improve this measure. Increasing earnings or paying off debt can improve the ratio. Cost-cutting can be an effective way to increase earnings, even if sales are not expanding. Refinancing existing debt can also reduce debt service payments and boost the times interest earned ratio.
The times interest earned ratio is an important measure of a company's ability to pay its debts and invest in its growth. A higher ratio indicates a lower risk to investors and lenders, while a lower ratio may signal potential financial difficulties. Companies, investors, and lenders use the ratio to assess the financial health and risk of a company. While the ratio has its limitations, it can provide valuable insights when used in conjunction with other financial measures.