Value of times interest earned

BY MATTHEW D. MOHR

One common financial ratio used by banks, credit, and accounting firms is the number of times a business earns the interest it pays annually. Typically a financial analyst will use the business net profit before tax and interest (EBIT) divided by the interest paid on its debt that year to calculate the ratio. This common calculation is used to assess the relative financial soundness (stability or solvency) of the business. A low number, especially compared to similar businesses, may indicate future or immediate trouble.

The measure is only a calculation of how much profit may be available to support interest costs. A ratio of 1.0 means the enterprise just makes enough money to pay the interest on its debt, which does not include the required debt principle payment. Usually a banker or credit analyst is smart enough to understand the times interest earned ratio is a rather simple measure and it is only used for limited decisions with minimal impact. A much better calculation to watch is the enterprise net annual cash flow, divided by required debt repayments, but the times interest earned ratio is still often used because it is strongly engrained into our financial systems.

An organization could have earnings before tax and interest of $200,000, loans of $850,000 with interest at an average of 4 percent, but loan payments of nearly $188,000 (assuming $850,000 debt at 4 percent interest with an average amortization of five years). Interest would be $34,000 per year on $850,000 debt at 4 percent. A net profit of $200,000 before interest and taxes would calculate a reasonable 5.88 times interest earned, but the profit before tax and interest barely covers annually required debt payments (assuming $850,000 debt at 4 percent to be repaid evenly over five years). Income after tax wouldn’t quite cover total annual debt repayment requirements in this situation.

The times interest earned ratio is a common measure of financial strength, but it can be misleading, so it’s good to calculate and understand it, but not to rely on the ratio for important decisions. PB

Matthew D. Mohr CEO, Dacotah Paper Co. mmohr@dacotahpaper.com