What is time interest earned ratio?
The time interest earned ratio will provide you the ability of an enterprise to repay the outstanding debt amount. The ratio is calculated by the division of the amount available to pay the interest expenses by the amount of total interest to be paid. Generally this ratio is used by the lenders to ascertain whether the borrowers of the money can afford the additional debt.
The formula to calculate the ratio is as follows:
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Times interest earned: Earnings before interest and taxes/ interest expense.
The analysis of the ratio
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A ratio of less than 1 indicates that a business is not in the position to pay the interest on more of the additional debt. So the lenders will not be attracted to give the loan to the business as the repayment capacity of such an enterprise is very weak. Well on the other side as the higher the answer to the ratio comes, the more amounts of loans can be made available as the condition of the enterprise is very good and the repayment capacity is also very high.
Some of the disadvantages/ drawbacks of using this formula
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- The ratio does not provide for the availability of the cash with an organization, the ratio may seem to be a positive one but at sometimes it is possible that an enterprise has a lot of profit but the cash availability with it is quite low and on the other hand it is possible that the ratio may seem quite low but the organization is having a plenty of cash which will be helpful for repaying the debt, so the lenders will lend money by seeing the ratio which will not help them have proper conclusion
- The amount of interest which is used in the ratio is not the one which is fixed all the time and thus it is not proper to take the interest amount in the denominator fixed as it may change due to discount and premiums when actually the amount is paid.
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- The biggest drawback of this ratio is that you don’t calculate the principal amount which is also to be paid by the organization. The principal amount shall also be considered as it is the main part of the repayment and it we do not see to the repayment then it may happen that the organization shall not be able to pay debt as the ratio was not calculated properly.
- The important thing is it will be based on the net profit which is the result of deducting the expenses from the gross profit, but in this expenses there will be notional expenses as well as like amortization and depreciation which will have the effect on the profit and loss statement but there will be no effect on the cash so the ability to repay the interest may seem low but the case will not be that simple.
Thus by this Financeshed explains how the time’s interest earned ratio is calculated and how to use the same keeping in mind the drawbacks of the same.