Which of the following best describes a limitation of the Times Interest Earned (TIE) ratio?

• A. It only considers long-term debt and excludes short-term liabilities.
• B. It is based on accounting profit, which may not reflect actual cash available to pay interest.
• C. It ignores the impact of taxes on a company's earnings.
• D. It measures a company's ability to pay dividends to shareholders.

Answer: (B)

Verified step by step guidance

1. Understand the Times Interest Earned (TIE) ratio: The TIE ratio measures a company's ability to meet its interest obligations using its earnings before interest and taxes (EBIT). The formula is TIE = EBIT / Interest Expense.
2. Identify the limitation being discussed: The question asks about a limitation of the TIE ratio, so focus on what the ratio does not account for or where it might fall short in providing a complete picture of a company's financial health.
3. Evaluate the options provided: Analyze each option to determine if it accurately describes a limitation of the TIE ratio. For example, consider whether the ratio excludes short-term liabilities, whether it is based on accounting profit, whether it ignores taxes, or whether it measures dividend-paying ability.
4. Focus on the correct limitation: The TIE ratio is based on accounting profit (EBIT), which is calculated using accrual accounting principles. This means it may not reflect the actual cash available to pay interest, as accounting profit includes non-cash items like depreciation and amortization.
5. Conclude the analysis: The correct limitation is that the TIE ratio is based on accounting profit, which may not reflect the actual cash available to pay interest. This is a key consideration when using the TIE ratio to assess a company's financial health.