Dear Professor Cram:
ABC Corp has 500,000 of debt outstanding, and it pays an interest rate of 10% annually. Annual sales of 2 million with a tax rate of 30% and a net profit margin of 5%. What is the ABC Corp TIE ratio? Somehow I missed the boat on this one. Can you help?
John S., US Navy
Thanks for your question, John. You may want to review some of our Debt Management Ratios. What you are looking for with Times Interest Earned, or TIE, is ABC Corp's ability to pay interest payments out of earnings.
First, let's calculate the interest payment. With $500,000 in debt at 10% annual interest, multiplying the two together gives us $50,000 in annual interest expenses. Earnings for $2,000,000 in sales, with 5% profit margin, is $100,000 in profit (before taxes). (Remember, figure the ratio BEFORE taxes because interest is a deductible expense and reduces taxes.)
So, what is the answer? $100,000 in earnings divided by $50,000 in interest yields a TIE ratio = 2.
As always with financial ratios, this value should be compared with TIE ratios for other companies in ABC Corp's industry to help put it in perspective. Anything less than 1.0 means the company isn't earning enough to pay the interest in their debt. A higher industry average than company value could either mean that this company uses more debt than the industry average, or that their earnings are inferior to the industry average. This is why one ratio by itself doesn't tell the whole story.