Solvency Analysis: Times Interest Earned

Making Sure a Company Can Pay Its Bills

Introduction

Sometimes, we need to check if a company can pay the money it owes for borrowing. This is important to know if the company is doing well and is financially strong. One way to figure this out is by using something called the "Times Interest Earned" ratio. It helps us see if a company can cover the interest it has to pay every year. Let's learn more about it!

Understanding Times Interest Earned

The Times Interest Earned ratio is like counting how many times a company's money can pay for the interest it owes. We want the company to have enough money to pay its bills without any trouble.

Times Interest Earned = How much money the company makes / How much interest it has to pay

Interpretation of Times Interest Earned

The Times Interest Earned ratio tells us if the company is good at paying its bills. If the ratio is high, it means the company has a lot of money to cover the interest payments. That's good because it means the company is not in much danger of running out of money. But if the ratio is low, it means the company might have a hard time paying its bills. That's not so good because it means the company is at risk of not having enough money.

Calculation of Times Interest Earned

To find the Times Interest Earned ratio, we need to look at two things:

• How much money the company makes: This is the money the company gets from its main business before it takes out any interest or taxes. It tells us if the company is making enough money to pay its bills.
• How much interest the company has to pay: This is the money the company owes for borrowing. It tells us how much the company needs to pay back to the people it borrowed from.

Significance of Times Interest Earned

The Times Interest Earned ratio is very important because it helps us know if a company can pay its bills. If the ratio is high, it means the company is doing well and can handle its debts. But if the ratio is low, it means the company might be in trouble and might not be able to pay its debts. By comparing the ratio to other companies and how the company did in the past, we can understand if the company is safe or risky.

Example

Let's imagine a company called Company XYZ:

Money the company makes (Operating Income): $500,000

Money the company owes (Interest Expense): $100,000

Times Interest Earned = $500,000 / $100,000

Times Interest Earned = 5

In this example, Company XYZ has a Times Interest Earned ratio of 5. That means the company has enough money to cover its interest payments five times over. It's like having lots of money left after paying its bills!

Conclusion

The Times Interest Earned ratio helps us know if a company can pay the money it owes for borrowing. It shows us how many times the company's money can cover the interest it has to pay. A high ratio means the company is good at paying its bills and is financially strong. We use this ratio to understand if the company is safe to invest in or if it might have trouble with its debts. By looking at the ratio, we can make smart decisions about investing and managing debts.

This article takes inspiration from a lesson found in FIN 689 at Pace University.