If you want to be a good investor, you need to be sure that you know what you’re investing in. While it’s easy to just “set it and forget it,” the best investors are those who have a thorough understanding of both the stock market and the companies they’ve invested in. There are a wide variety of aspects to consider when evaluating a business that you plan to be an investor of, including something known as a times interest earned ratio. While times interest earned ratio, or TIE ratio, sounds like an elaborate concept, it’s not actually as complicated as you might think. Here’s a quick rundown of what a TIE ratio really means when it comes to a company’s earnings.
What does the TIE ratio signify?
The TIE Ratio is, at its heart, a measure of a company’s ability to handle its debt obligations. Just because a company is making a lot of money doesn’t mean that it’s necessarily being run well. In fact, many businesses aren’t the most reliable borrowers, so knowing if their current net income is enough to handle their debt obligations will determine how a company will perform on a long-term basis.
How do you calculate a TIE ratio?
When it comes to calculating the TIE ratio, the formula is actually quite simple. All it requires you to do is divide the business’ income before taxes and interest, by the interest expense. This gives you a good indication of how able a business will be to properly handle its debt and interest obligations. For example, if the times interest earned ratio is 1 or less, then it’s likely that the business isn’t going to be able to cover its interest expenses. However, if the TIE ratio is above 1, then the business probably has enough income to cover its debt and interest payments. In fact, the higher the ratio is, the easier it is for the business to handle its interest charges.
So, what does a times interest earned ratio of 10 times indicate?
If the TIE ratio of a company is 10, that means that the annual income before interest and taxes is ten times as much as the annual interest expense. As such, a financial institution is likely to categorize a company with a TIE ratio of 10 as highly stable and quite low-risk. Keep in mind that a TIE ratio of 5 is also considered as being low-risk, so if you’re investing in a company that has a high ratio, you shouldn’t have to worry too much about whether or not they take on additional debt.
How can a times interest earned ratio help you pick a good company to invest in?
The TIE ratio can help you pick solid companies to invest in by giving you a good understanding of a business’s solvency potential. The higher ratio helps you know that a company is less susceptible to solvency, whereas a lower ratio could mean that a company may not have enough money to cover its debts and pay the cost of goods on a long-term basis. If you want to invest in a business that’s likely to avoid bankruptcy, then choose one with a higher TIE ratio, as it is a safer bet. That being said, a TIE ratio that’s quite high could also mean that the business might not actually be managing its debt appropriately. For example, if a business’ times interest ratio is significantly above average, then you might want to take a look at some of their other financial statements. After all, there’s usually no reason for a company to carry any amount of debt if it’s truly maximizing its profits.