14. Financial Statement Analysis
Ratios: Times Interest Earned (TIE)
Ratios: Times Interest Earned (TIE)
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Alright, let's discuss another ratio here. The times interest earned ratio. So times interest earned. It's gonna help analyze how we cover our interest expense. Alright. So remember we're gonna have when we have loans, we're gonna have interest that we have to pay every period on this loan. Well, how are we making the money to cover that interest? That's what the times interest earned ratio helps us discover. So times interest earned. It's a common solvency ratio, right? It helps us know how solvent we are. How much are we able to pay our debts? Okay. There are different ways to calculate the times interest earned ratio. We're gonna discuss the two most common ways here, but you'll notice that they calculate very similar results when we when we discuss it. But just double check with your professor to see how they calculate this ratio, right? Because sometimes they'll just use the first one. Sometimes they use the second one. They're gonna pick one and they're gonna stick to it. That's generally how this goes. All right, So let's go ahead and go through the two of them. The most common way to calculate it is through this first ratio, Times interest earned. It's gonna be our operating income divided by our interest expense. Okay. So what does this tell us our operating income? This is income that we're getting from our core business, right? We're getting the sales that we make minus the cost of the sales minus our operating expenses, right, necessary expenses of our business, like rent, like depreciation, write these necessary expenses salaries that we must pay. Well, what's left after that point? This operating income, can it pay for our interest expense? Okay, That's what the times interest earned is telling us. Or another way to calculate it is to start from the bottom and move our way up, Right? So we can have net income, right? That's our bottom line on our income statement. And we're gonna add some things to it. We'll put back the interest expense. Right? Because that's what we're looking for. The in expense in the denominator. Remember, interest expense isn't part of our operating income. This is a non operating expenses. Usually how we classify this. So our net income, we're going to add back our interest expense and add back our income tax expense. Alright. These are the two most common non operating expenses that we see. So that kind of gets us back to operating income in essence. Alright, So again, we take that and divide it by interest expense. So what this tells us is how many times we could cover our interest expense with our core income. Right? So we're gonna have this interest expense that's going to be stable every period. Maybe we have to pay 50,000 in interest every year. Right? What we we should be making from our operations at least that 50,000, right? If our operations can't make as much as we're paying to the bank in interest. Well, something's going wrong here, right? And usually how we use this ratio is usually when we have a loan with a bank, they're going to require some level of times interest earned. So the bank is going to regularly check our financial statements and check if we're maintaining the times interest earned that's in our contract. So the contract would say that we must maintain a times interest earned of three X. Okay. And if we don't maintain that well, we could default on our loan that can make our whole loan do right now because we've defaulted on that part of the contract. All right. So it's a very important ratio when we're dealing with loans the times interest earned. And it's always shown like this with an X. Right? Like three times our operating income is three times our interest expense, something like that. Okay. So we always want this to be really high the higher the times interest earned. Well, that means we have better solvency, right? Because we're gonna be able to cover that interest expense many times. Cool. So let's go ahead. It's a pretty simple formula. Let's just jump into some practice and you guys try and calculate some times interest earned ratios.
XYZ Company had Income from Operations of $320,000 and Net Income of $80,000. Interest Expense during the current period was $40,000 and Notes Payable totaled $400,000. What is the company’s Times Interest Earned?
ABC Company had Net Income during the period of $60,000 after Income Taxes of $40,000. Furthermore, the company had outstanding Notes Payable at the beginning and end of the year, respectively, of $250,000 and $350,000. If interest expense was $15,000 during the period, what is the company’s TIE ratio?