The times interest earned ratio indicates a firm’s long-term debt-paying ability from the income statement view. If the times interest earned is adequate, little danger exists that the firm will not be able to meet its interest obligation.
In contrary, if the firm has good coverage of the interest obligation, it should also be able to refinance the principal when it comes due. In effect, the funds will probably never be required to pay off the principal if the company has a good record of covering the interest expense.
A relatively high, stable coverage of interest over the years indicates a good record. A low, fluctuating coverage from year to year indicates a poor record. Companies that maintain a good record can finance a relatively high proportion of debt in relation to stockholders’ equity and, at the same time, obtain funds at favorable rates.
Utility companies have traditionally been examples of companies that have a high debt structure, in relation to stockholders’ equity. They accomplished this because of their relatively high, stable coverage of interest over the years. This stability evolved in an industry with a regulated profit and a relatively stable demand.
During the 1990s, utilities experienced a severe strain on their profits, as rate increases did not keep pace with inflation. In addition, the demand was not as predictable as in prior years. The strain on profits and the uncertainty of demand influenced investors to demand higher interest rates from utilities than had been previously required in relation to other companies.
A company issues debt obligations to obtain funds at an interest rate less than the earnings from these funds. This is called trading on the equity or leverage. With a high interest rate, the added risk exists that the company will not be able to earn more on the funds than the interest cost on them.
Times Interest Earned is computed as follows:
(Recurring Earnings, Excluding Interest –
Expense, Tax Expense, Equity Earnings, and Minority Earnings)
Interest Expense, Including Capitalized Interest
The income statement contains several figures that might be used in this analysis. In general, the primary analysis of the firm’s ability to carry the debt as indicated by the income statement should include only income expected to occur in subsequent periods. Thus, the following nonrecurring items should be excluded:
- Discontinued operations
- Extraordinary items
- Cumulative effect of a change in accounting principle
In addition to these nonrecurring items, additional items that should be excluded for the times interest earned computation include:
1. Interest expense – This is added back to net income because the interest coverage would be understated by one if interest expense were deducted before computing times interest earned.
2. Income tax expense – Income taxes are computed after deducting interest expense, so they do not affect the safety of the interest payments.
3. Equity earnings (losses) of non-consolidated subsidiaries – These are excluded because they are not available to cover interest payments, except to the extent that they are accompanied by cash dividends.
4. Minority income (loss) – This adjustment at the bottom of the income statement should be excluded; use income before minority interest. Minority income (loss) results from consolidating a firm in which a company has control but less than 100% ownership.
All of the interest expense of the firm consolidated is included in the consolidated income statement. Therefore, all of the income of the firm consolidated should be considered in the coverage.
Capitalization of interest results in interest being added to a fixed asset instead of expensed. The interest capitalized should be included with the total interest expense in the denominator of the times interest earned ratio because it is part of the interest payment. The capitalized interest must be added to the interest expense disclosed on the income statement or in footnotes.
An example of capitalized interest would be interest during the current year on a bond issued to build a factory. As long as the factory is under construction, this interest would be added to the asset account, construction in process, on the balance sheet. This interest does not appear on the income statement, but it is as much of a commitment as the interest expense deducted on the income statement.
When the factory is completed, the annual interest on the bond issued to build the factory will be expensed. When expensed, interest appears on the income statement. Capitalized interest is usually disclosed in a footnote. Some firms describe the capitalized interest on the face of the income statement. Below is an example of Times Interest Earned for 2011 and 2010:
Many would consider this ratio to be high. To evaluate the adequacy of coverage, the times interest earned ratio should be computed for a period of three to five years and compared to competitors and the industry average.
Computing interest earned for three to five years provides insight on the stability of the interest coverage. Because the firm needs to cover interest in the bad years as well as the good years, the lowest times interest earned in the period is used as the primary indication of the interest coverage. A cyclical firm may have a very high times interest earned ratio in highly profitable years, but interest may not be covered in low profit years.
Interest coverage on long-term debt is sometimes computed separately from the normal times interest earned. For this purpose only, use the interest on long-term debt, thus focusing on the long-term interest coverage. Since times interest earned indicates long-term debt-paying ability, this revised computation helps focus on the long-term position.
For external analysis, it is usually not practical to compute times interest coverage on long-term debt because of the lack of data. However, this computation can be made for internal analysis.
In the long run, a firm must have the funds to meet all of its expenses. In the short run, a firm can often meet its interest obligations even when the times interest earned is less than 1.00. Some of the expenses, such as depreciation expense, amortization expense, and depletion expense, do not require funds in the short run. The airline industry has had several bad periods when the times interest earned was less than 1.00, but it was able to maintain the interest payments.
To get a better indication of a firm’s ability to cover interest payments in the short run, the non-cash expenses such as depreciation, depletion, and amortization can be added back to the numerator of the times interest earned ratio. The resulting ratio, which is less conservative, gives a type of cash basis ‘times interest earned’ useful for evaluating the firm in the short run. Below is an example of ‘Times Interest Earned’ for 2011 and 2010 in shorter run perspective which is higher than its long-run ratio:
Note: *In the financial report, amortization and other were combined. The total amount was used because there was no way to determine the amount for amortization and the amount for other.