Which of the following is the correct formula for calculating the Times Interest Earned (TIE) ratio?

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

Answer: (B)

Verified step by step guidance

1. Step 1: Understand the 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. The formula is: \( \text{TIE} = \frac{\text{Earnings Before Interest and Taxes (EBIT)}}{\text{Interest Expense}} \). This formula shows how many times a company can cover its interest expense with its operating income.
3. Step 3: Clarify why EBIT is used in the formula. EBIT represents the company's operating income before deducting interest and taxes, making it the most relevant measure of income for evaluating interest coverage.
4. Step 4: Compare the incorrect options. \( \text{TIE} = \frac{\text{Total Assets}}{\text{Interest Expense}} \) is incorrect because assets are not related to income generation. \( \text{TIE} = \frac{\text{Net Income}}{\text{Interest Expense}} \) is incorrect because net income includes deductions for taxes and interest. \( \text{TIE} = \frac{\text{Earnings Before Taxes (EBT)}}{\text{Interest Expense}} \) is incorrect because EBT excludes interest expenses.
5. Step 5: Conclude that the correct formula for TIE is \( \text{TIE} = \frac{\text{Earnings Before Interest and Taxes (EBIT)}}{\text{Interest Expense}} \), as it directly measures the company's ability to cover interest expenses using its operating income.