When it comes to making good investments, it’s crucial that you have a solid understanding of both the stock market and what you’re investing in. The old saying that “knowledge is power” is very much true in the world of personal finance, so if you don’t have the proper facts, then you aren’t likely to be making the most of your investments.
Whether you’re investing in a company outright, or are just looking to make more responsible investment decisions, it’s crucial to have a firm understanding of the types of business metrics you should be using to evaluate each company’s potential for investment. One such metric is something known as times interest earned ratio or the TIE ratio.
Here’s a quick overview of the TIE ratio, including what constitutes as good time interest and what sorts of ratios you should be avoiding.
What does the TIE ratio measure?
At its core, the TIE ratio is an accounting calculation which determines a business’s solvency, or how likely it is to go bankrupt. The times interest earned ratio does this by representing how much debt and any interest obligations the business has, in comparison to its income. The result of this is a value that acts as a measure of a company’s ability to either stay up to date and current with its business debt obligations, or demonstrate if it’s at risk for falling behind.
Remember that just because a business is selling a lot of units doesn’t necessarily mean that the company is being run properly. Sometimes, the debt incurred through business loans, credit, and other means of production eclipses the company’s income generated through sales. This means that a business which seems to be performing well could actually be in trouble. As an investor, you want to be investing in a company that is sucessful over a long-term basis, and a TIE ratio can give you a good idea of whether or not the business you’re looking at actually has legs or not.
How is the TIE ratio calculated?
To calculate the TIE ratio, first remember the acronym EBIT. EBIT stands for “earnings before interest and taxes.” To determine a company’s TIE ratio, you must divide its EBIT by its total interest expenses. Remember that the value of the total interest expense you use should include interest payments on all debts and bonds, so that you’re getting the full picture.
After performing the accounting calculation of dividing the company’s EBIT by its total interest expenses, the resulting number will demonstrate the number of times that a company can clear all of its debts.
What does a good TIE ratio look like?
Generally speaking, any TIE ratio with a value of 1.0 or lower is considered bad or financially risky. The larger the TIE ratio, the more likely it is that a business has enough money to cover payments to its lenders and creditors without completely running out of income. For example, a times interest earned ratio of 5.0 is generally considered quite solid, as that means that a company has five times as much income than it has debt. (Or, it could pay off all of it’s debt five times, before running out of money.) This means that the company is a good borrower.
If push came to shove, the company’s earnings and net income could cover this debt or even take on new loans and additional debt without increasing its solvency ratio.
What else is important to keep in mind regarding TIE ratios and investments?
When you’re using the financial statements of a company to evaluate what or not you want to invest in it, it’s easy to get stuck in the weeds. That being said, there are a few things to keep in mind when it comes to using a TIE ratio as an indicator of a company’s potential for investment. For example, while a high TIE ratio is generally seen as a positive thing, it’s important to compare that higher ratio to other financial ratios and benchmarks within the industry. This is because a higher-than-average TIE ratio could be a sign that the company is mismanaging its debts by not paying them off in full when they could.
Make sure you think critically as you investigate a company’s financial statements in order to make a sound investment.
