How much of a company’s earnings are available to cover the interest on its debt? That’s an important question for investors who want to quantify the risk of potential investments. The answer is found in the “times interest earned ratio,” which is also called the "interest coverage ratio."
In his 2012 book, “Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet,” Axel Tracy included three ratios in the section on leverage ratios. First, the debt ratio, which analyzes liabilities or debt in terms of assets; second, the debt-to-equity ratio, which, as the name makes clear, assesses debt in terms of equity; and third, the times interest earned ratio, which addresses debt in the context of earnings.
So, three different ratios, three comparisons: to assets, to stockholders' equity and to earnings.
He explained the latter as “purely a risk measure and the calculation tells us how many times over a company’s earnings, specifically its earnings before interest and tax (EBIT), can be used to meet its interest payments.”
Tracy wrote that the times interest earned ratio is a measure that tells us about debt serviceability. He wrote, “It explains how easily (or not) a business can service its debts. The higher the ratio, the more times over its EBIT can meet its interest expense, the easier it can service its debt and the safer a business appears to be.”
It is based on this formula:
“Times Interest Earned Ratio = (Income Before Tax + Interest Expense) / Interest Expense”
For example, Income Before Tax ($2 million) + Interest Expense ($1 million) divided by Interest Expense ($1 million) = Times Interest Earned Ratio (3). If a company has income before tax, plus an interest expense of $3 million, it has enough earnings power to repay its debt three times over. More simply, this company has more earnings before interest and taxes than it needs to cover its liabilities (debt). Data for the ratio comes from the income statement.
GuruFocus provides a similar metric, the Debt-to-EBITDA ratio. It differs from the times interest earned ratio because it factors in depreciation and amortization as well as taxes and interest expenses. For example, this excerpt shows the Debt-to-EBITDA ratio for PepsiCo (PEP, Financial):
Here we see that PepsiCo has enough earnings (before interest, taxes, depreciation and amortization) to pay its current liabilities 2.3 times over. In other words, it is quite healthy and faces no threat of being unable to handle its debt obligations.
Once again, I recommend you also consult the weighted average cost of capital verus return on invested capital metric, which is found just a bit below the debt-to-EBITDA ratio. For PepsiCo, it’s an important relationship: It pays 4.41% for its invested capital (both debt and equity) while earning 35.77% on that capital. In relation to the times interest earned ratio, it is a bit of an apples and oranges comparison, but does give us a solid indication that the company has managed its debt and liabilities well.
In discussing changes in the times interest earned ratio, Tracy starts with an obvious but important point: the existence of the ratio shows the company has debt. If the ratio shows up as zero or blank, then the company has no debt and investors can have faith that there is no risk of default or bankruptcy.
Companies can change their policies, though, and begin using debt to either bolster sales and earnings or to keep afloat if it gets into financial trouble. As noted, times interest earned is a debt serviceability ratio and tells us how much capacity a company has to pay its interest expenses as they come due.
The ratio can go up or down. Tracy summarized this way:
“So, if the Times Interest Earned Ratio is changing then this margin of safety (risk) is changing. Ideally you want the ratio to be increasing over time as this means you are finding it easier to service debts from your earnings and allow for further growth or investments.
If the ratio is falling over time, then this means either you are earning less from operations (other things being equal) or you have taken on more debt (with a higher interest expense) but you do not have a corresponding increase in EBIT as a result of the extra borrowings. Neither of these cases is positive news for a business, both as performance measures nor as risk measures.”
He also reported that the main drawback of this ratio is its inability to definitively tell whether a business could potentially go broke. That’s because it only uses earnings before taxes and interest (EBIT), while other leverage ratios show that assets on the balance sheet may be available. And there is also the possibility of issuing new shares.
Tracy concluded his discussion of the times interest earned ratio with these words: “So while it is a good risk measure, it should probably be used in conjunction with other leverage ratios. You should review the level of assets in the business in relation to total debt and maybe even the business’ success with previous capital raisings.”
Conclusion
The times interest earned ratio tells us about the capacity of a company to service the interest on its debts. It matters because an inability to meet interest payments suggests a company could be in financial danger.
It is one of three leverage metrics: The debt ratio measures debt against a company’s assets, the debt-to-equity ratio measures it against stockholders' equity and times interest earned measures it against a company’s earnings before interest and taxes.
None of these ratios is robust enough to be taken on its own; instead, each one should be just one part of a broader examination of a company’s financial health.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Risk Analysis: The Debt-to-Equity Ratio
- Ratio Analysis: The Debt Ratio
- Ratio Analysis: The Acid-Test Ratio
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