The times interest earned ratio, also known as the interest coverage ratio, measures a company's ability to meet its interest payment obligations. It is a key solvency ratio that indicates a company's financial health and its capacity to pay its debts.
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The times interest earned ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense.
A higher times interest earned ratio indicates a company's greater ability to meet its interest payment obligations, with a ratio of 3 or more generally considered healthy.
The times interest earned ratio is used by lenders and investors to assess a company's creditworthiness and its capacity to take on additional debt.
A low times interest earned ratio, typically below 1.5, may suggest a company is at risk of defaulting on its debt payments and could face financial distress.
The times interest earned ratio is particularly important for companies with significant debt levels, as it provides insight into their financial leverage and debt servicing capabilities.
Review Questions
Explain the purpose and significance of the times interest earned ratio in the context of solvency ratios.
The times interest earned ratio is a key solvency ratio that measures a company's ability to meet its interest payment obligations. It provides insight into the company's financial health and its capacity to take on additional debt. A higher ratio indicates a stronger ability to cover interest expenses, while a lower ratio may suggest financial distress and a higher risk of default. This ratio is particularly important for companies with significant debt levels, as it helps lenders and investors assess the company's creditworthiness and its overall financial stability.
Describe how the times interest earned ratio is calculated and interpret the implications of different ratio values.
The times interest earned ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense. A ratio of 3 or more is generally considered healthy, indicating the company has a strong ability to meet its interest payment obligations. A ratio below 1.5 may suggest the company is at risk of defaulting on its debt payments and could face financial distress. The times interest earned ratio is used by lenders and investors to assess a company's creditworthiness and its capacity to take on additional debt, providing insights into the company's financial leverage and debt servicing capabilities.
Analyze how the times interest earned ratio relates to other solvency ratios and its overall significance in evaluating a company's financial stability and long-term viability.
The times interest earned ratio is a key component of solvency ratios, which measure a company's ability to meet its long-term debt obligations and overall financial stability. While the times interest earned ratio specifically focuses on a company's capacity to cover its interest expenses, it provides a broader perspective on the company's financial health when considered alongside other solvency ratios, such as the debt-to-equity ratio and the current ratio. Together, these ratios offer a comprehensive assessment of a company's financial leverage, liquidity, and its ability to sustain operations and service its debt in the long term. The times interest earned ratio is particularly crucial for companies with significant debt levels, as it helps lenders and investors evaluate the company's creditworthiness and its capacity to take on additional debt without risking financial distress or default.
Solvency ratios are a group of financial ratios that measure a company's ability to meet its long-term debt obligations and overall financial stability.
A measure of a company's operating profit that excludes interest and income tax expenses, providing insight into the company's core business performance.