Which of the following formulas is used to compute the Times Interest Earned (TIE) ratio?

• A. TIE = \frac{\text{Earnings Before Interest and Taxes (EBIT)}}{\text{Interest Expense}}
• B. TIE = \frac{\text{Total Assets}}{\text{Total Liabilities}}
• C. TIE = \frac{\text{Gross Profit}}{\text{Interest Expense}}
• D. TIE = \frac{\text{Net Income}}{\text{Interest Expense}}

Answer: (A)

Verified step by step guidance

1. Step 1: Understand the concept of Times Interest Earned (TIE) ratio. It is a financial metric used to measure a company's ability to meet its interest obligations. The formula involves Earnings Before Interest and Taxes (EBIT) and Interest Expense.
2. Step 2: Identify the correct formula for TIE ratio. The formula is TIE = \frac{\text{Earnings Before Interest and Taxes (EBIT)}}{\text{Interest Expense}}.
3. Step 3: Analyze why other formulas provided in the problem are incorrect. For example, TIE = \frac{\text{Total Assets}}{\text{Total Liabilities}} is not related to interest coverage but rather to the financial structure of the company. Similarly, TIE = \frac{\text{Gross Profit}}{\text{Interest Expense}} and TIE = \frac{\text{Net Income}}{\text{Interest Expense}} do not accurately reflect the company's ability to cover interest expenses.
4. Step 4: Recognize that EBIT is used in the formula because it represents the earnings available to pay interest before considering interest and taxes, making it the most relevant metric for this calculation.
5. Step 5: To compute the TIE ratio, divide the company's EBIT by its Interest Expense using the formula TIE = \frac{\text{EBIT}}{\text{Interest Expense}}. This will provide the number of times the company can cover its interest obligations with its earnings.