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Calculate the times interest earned of Weldon Furniture, when:
Times interest earned = Earnings before interest and tax ÷ interest expense = $3,493,000 ÷ $239,000 =14.6
Calculate the interest expense for Seabold Art and Framing, when:
Interest Expense = earnings before interest and tax ÷ time interest earned ratio = $1,324,400 ÷ 9.34 = $141,800
Also known as the interest coverage ratio, times interest earned is calculated as earnings before interest and tax (EBIT) of a business divided by its interest expense during a given period.
This ratio measures solvency, the ability of a company to pay its debts. So, it has a special importance to creditors. Ratio values indicate whether a company’s earnings are available to meet interest payments. Analysts use this ratio to compare the debt repayment ability of companies. When other conditions are roughly equal, creditors are more likely to lend to companies with the highest ratio values. Measuring a company’s times interest earned trend is a helpful way to diagnose its financial health.
The higher the ratio value, the more likely a business is to repay its interest and debt. So, higher ratio values are more favorable, lower values are less favorable. When the ratio value is less than 1, the company cannot generate enough cash from its operations EBIT to meet its interest owed. When this occurs, companies must make up the difference by using use cash on hand or borrow funds. Generally, ratio values less than 2.5 are considered a warning sign that requires follow-up.