May 15, 2024
by Andrew Zangre / May 15, 2024
Have you ever bitten off more than you can chew?
It happens to the best of us — with projects, responsibilities, or forkfuls of salad.
One goal of banks and loan providers is to ensure you don’t do so with money or, more specifically, with debts used to fund your business operations.
In a perfect world, companies would use accounting software and diligence to know their position and not consider a hefty new loan or expense they couldn’t safely pay off. But even a genius CEO can be a tad overzealous and watch as compound interest capsizes their boat.
The times interest earned (TIE) formula was developed to help lenders qualify new borrowers based on the debts they’ve already accumulated. It gave the investors an idea of shareholder's equity metric and interest accumulated to decide if they could fund them further.
The times interest earned ratio, or interest coverage ratio, is the number of times you can pay your outstanding loans and debts with your earnings before tax and amortization (EBITA) or earnings before tax (EBIT). This ratio determines whether you are in a position to pay the interest to the venture capitalists for fundraising with your retained earnings.
If your current revenue is just enough to keep your debts in check —and the lights on in your office — you are not a logical or responsible bet for a potential lender (e.g., investors, creditors, loan officers).
With the interest formula, these lenders can measure your financial fitness as it relates to these matters based on information from your income statements. The amounts used in the equation are: A) your earnings before interest and taxes and B) your interest expense, or the current cumulative interest compiled from your debts.
To use this formula, you must be an established business that has a source capital stream and an active transactional accounting period. It can be calculated by referring to your income statement, the row under the revenue column, and the "total interest paid". The total interest is an expense that determines all your liabilities to venture capitalists and moneylenders. The formula for TIE becomes:
TIE ratio: Earnings before interest and taxes (EBIT) / total interest expense
In services industries, the formula could also be
TIE ratio: Earnings before interests, taxes, and amortization (EBITA) / interest expense
The higher the TIE, the better the chances you can honor your obligations. A TIE ratio of 5 means you earn enough money to afford 5 times the amount of your current debt interest — and could probably take on a little more debt if necessary.
A low TIE suggests that you have more outstanding than your current capital. Capital can include shareholder equity, current assets, accounts receivable, and sales revenue. Not having enough EBITA can burn your profit margins and restrict cash flow.
A TIE ratio of 2.5 is considered the dividing line between fiscally fit and not-so-safe investments. Lenders make these decisions on a case-by-case basis, contingent on their standard practices, the size of the loan, and a candidate interview, among other things. But the times interest earned ratio formula is an excellent metric to determine how well you can survive as a business. Earn more money and pay your debts before they bankrupt you, or reconsider your business model.
Your company’s earnings before interest and taxes (EBIT) are pretty much what they sound like. This number measures your revenue, taking all expenses and profits into account, before subtracting what you expect to pay in taxes and interest on your debts.
Simply put, your revenues minus your operating costs and expenses equals your EBIT. Expenses include things like building fees and the cost of goods sold.
Example: If you bring in $10,000 this month and your overall expenses total $2,000, your EBIT for this month is $8,000. Your EBIT for the year is then projected at $96,000.
Ultimately, you must allocate a percentage for your varied taxes and any interest collected on loans or other debts. Your net income is the amount you’ll be left with after factoring in these outflows. Any chunk of that income invested in the company is referred to as retained earnings.
Besides a zero-interest period on a credit card or a few bucks between friends, loans, and lines of credit come with an interest rate, that is, an amount tacked on every month or year based on a predetermined percentage of the total or the balance.
If you have three loans generating interest and don’t expect to pay those loans off this month, you must plan to add to your debts based on these different interest rates. This additional amount tacked onto your debts is your interest expense.
If you have a $10,000 line of credit with a 10 percent monthly interest rate, your current expected interest will be $1,000 this month. If you have another loan of $5,000 with a 5 percent monthly interest rate, you will owe $250 extra after the interest is processed. Your total interest expense for this month, then, is $1,250. For the year, it’s projected at $15,000.
So long as you make dents in your debts, your interest expenses will decrease month to month. But at a given moment, this amount can be hundreds or thousands of dollars piling onto your plate, in addition to your regular payments and other business expenses. The times interest earned formula is calculated on your gross revenue that is registered on your income statement, before any loan or tax obligations. This is also known as EBIT or EBITA. The ratio is not calculated by dividing net income with total interest expense for one particular accounting period. It is only a supporting metric of the financial stability and cash arm of your business which determines that you have the ability to clear off your liabilities with whatever you earn.
So let’s say you own a family deli. Let’s call it, “Hold the Mustard.”
The deli is doing well, making an average of $10,000 a month after expenses and before taxes and interest. This is an EBIT of $120,000 for the year. You took out a loan of $20,000 last year for new equipment and it’s currently at $15,000 with an annual interest rate of 5 percent. You have a company credit card for random necessities, with a current balance of $5,000 and an annual interest rate of 15 percent.
Due to Hold the Mustard’s success, your family is debating a major renovation that would cost $100,000. To fund this you are considering a loan with a local bank.
Your company’s statement of income will likely calculate the interest expense for you, but here is a breakdown of how that number is reached:
Loan #1:
Credit card:
Total interest expense: $750 + $750 = $1,500
When you sit down with the financial planner to determine your TIE ratio, they plug your EBIT and your interest expense into the TIE formula.
$120,000 (EBIT) ÷ $1,500 (Interest Expense) = 80 (TIE ratio)
Based on the times interest earned formula, Hold the Mustard has a TIE ratio of 80, which is well above acceptable. This bodes well for your potential loan. As we previously discussed, there is a lot more than this basic equation that goes into a lender’s decision. But you are on top of your current debts and their respective interest rates, and this will absolutely play into the lender’s decision process.
The deli down the street is your fierce rival, regularly insulting Hold the Mustard and stealing your customers with flashy promotions. Let’s call them, “Dill With It.”Their food isn’t even that good.
Dill With It makes $20,000 a month before taxes and interest. That’s an EBIT of $240,000 for the year. But they’ve got debt stacked high as the dirty dishes in their sink.
Dill’s founders are still paying off the startup loan they took at opening, which was $1,000,000. The balance is $800,000 with an annual interest of 10 percent. Last year they went to a second bank, seeking a loan for a billboard campaign. The balance is $30,000 with a 15 percent annual interest. The founders each have “company credit cards” they use to furnish their houses and take vacations. The total balance on those credit cards is $50,000 with an annual interest rate of 20 percent.
Here’s a breakdown of this company’s current interest expense, based on its varied debts.
Loan No. 1:
Loan No. 2
Credit cards:
Total interest expense: $80,000 + $6,000 + $10,000 = $96,000
Now the sleazeballs at Dill With It want to take out a third loan, to buy and demolish the green space next to their building to make way for a parking lot. Because, of course they do.
When they arrive at the loan servicing office, their clerk takes information from their income statement and plugs it into the times interest earned formula.
$240,000 (EBIT) ÷ $96,000 (Interest Expense) = 2.5 (TIE ratio)
Based on this TIE ratio — hovering near the danger zone — lending to Dill With It would probably not be deemed an acceptable risk for the loan office. Again, there is always more that goes into a decision like this, but a TIE ratio of 2.5 or lower is generally a cause for concern among creditors.
If they are declined, Dill With It might have to deal with it.
There is no generalized way of calculating a TIE ratio because it varies from industry to industry. It basically is a supporting metric that determines if you are eligible to stake equity or grow a business with more funding. Here are some limitations of the TIE ratio:
To have a detailed view of your company's total interest expense, here are other metrics to consider apart from times interest earned ratio.
By analyzing TIE in conjunction with these metrics, you get a better understanding of the company's overall financial health and debt management strategy.
Impact of Economic Downturns
As economic downturns have a significant impact on all accounting operations of a business, it also possesses the ability to turn a good TIE ratio into a low TIE ratio, which hinders business growth. The onset of recessions, layoffs, demand inelasticity, pandemics, or lower sales and profits could result in much lower EBIT, which would essentially be all of the sales revenue you have earned for a short time period. Lower EBIT would imply a weak financial muscle. This means that you will not find your business able to satisfy moneylenders and secure your dividends. More expenditure means less TIE, and ultimately means that you need loan extensions or a mortgage facility if you want to keep on surviving in the business world. Downturns like these also make it hard for companies to convert their sales into cash, hindering their ability to meet debt obligations even with a good TIE ratio.
You can’t just walk into a bank and be handed $1 million for your business. With that said, it’s easy to rack up debt from different sources without a realistic plan to pay them off. If you find yourself with a low times interest earned ratio, it should be more alarming than upsetting. Even if it stings at first, securing a strategy to earn more sales revenue and work hard to maintain a positive net cash flow can salvage your interest payments and put you in a position to curb outstanding debts.
Learn more about how to prep yourself for an SBA loan that can help grow your business and have cash reserves so that you can build better product experiences.
.
Zangre is a former Senior Research Specialist who helped with spearheading G2's expansion into B2B Services. He studied journalism at the University of North Florida — which is still undefeated in football — and joined G2 in 2016 when there was only one other “Andrew.” He has enjoyed contributing to newspapers and online publications while pursuing music and comedy projects in his free time.
Each sales dollar you make leaves you some profit.
by Maddie Rehayem
People in investing often look for options that promise security and potential for high-...
by Maddie Rehayem
Debt can be scary when you’re paying off college loans or deciding whether to use credit to...
by Maddie Rehayem
Each sales dollar you make leaves you some profit.
by Maddie Rehayem
People in investing often look for options that promise security and potential for high-...
by Maddie Rehayem