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 where they stand, 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’s a worthwhile measure to ensure companies keep chugging along and only take on as much as they can handle.
What is the times interest earned ratio?
The times interest earned ratio, or interest coverage ratio, is the number of times over you could feasibly pay your current debt interests. 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 compiling from your debts.
Times interest earned ratio formula
Earnings before interest and taxes (EBIT) ÷ interest expense = TIE ratio
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 current 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 is an excellent entry point to the conversation.In short, if your ratio is low, you got to go. Earn more money and pay your dang debts before they bankrupt you, or, reconsider your business model.
What is EBIT?
Your company’s earnings before interest and taxes (EBIT) are pretty much what they sound like. This number is a measure of your revenue with all expenses and profits considered, before subtracting what you expect to pay in taxes and interest on your debts.
In simpler terms, 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 a total of $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.
In the end, you will have to allocate a percentage of that for your varied taxes and any interest collecting 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 back in the company is referred to as retained earnings.
What is interest expense?
Besides a zero-interest period on a credit card or a few bucks between friends, loans and lines of credit will usually come paired 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 that are generating interest and don’t expect to pay those loans off this month, you have to plan to add to your debts based these different interest rates. This additional amount tacked onto your debts is your interest expense.
Example: If you have a $10,000 line of credit with a 10 percent monthly interest rate, your current expected interest on that credit 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. This is an important number for you to know, as a piece of your company’s pie will be necessary to offset the interest each month. It can also help put things in perspective and motivate you to pay down your debts sooner. Allowing interest to gather is basically setting money on fire.
For prospective lenders, a high interest expense compared to to your earnings can be a red flag. If the water is filling your glass faster than you can drink it, it’s fair to say you should not be given more — more debt means more interest. This, in a nutshell, is why the times interest earned formula exists.
Examples of times interest earned
So let’s say you’ve 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.
Calculating interest expense
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:
Current balance = $15,000
Annual interest = 5 percent
Interest for this year = $750
Current balance = $5,000
Annual interest = 15 percent
Interest for the year = $750
Total interest expense:
$750 + $750 = $1,500
Calculating total interest earned
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.
Additional TIE example
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.
Calculating business interest expense
Here’s a breakdown of this company’s current interest expense, based on its varied debts.
Loan No. 1:
Current balance = $800,000
Annual interest = 10 percent
Interest for this year = $80,000
Loan No. 2
Current balance = $40,000
Annual interest = 15 percent
Interest for the year = $6,000
Current balance = $50,000
Annual interest = 20 percent
Interest for the year = $10,000
Total interest expense:
$80,000 + $6,000 + $10,000 = $96,000
Calculating business times interest earned
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 — which is 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.
Address your debts
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, the bank is probably right to not loan you more.
If you find yourself in this uncomfortable position, reach out to a financial consulting provider to explore how your company got here and how it can get out. This may entail consolidating your debts and perhaps some painstaking decisions about your business. We encourage you to stay ahead of the curve and notice potential for such problems before they arise. Accounting firms can work with you along the way to help keep your ratios in check.
When the time a right, a loan may be a critical step forward for your company. Learn more about SBA loan preparation so you start on the right foot.