15RQ - Horngren'S Financial And Managerial Accounting

Question

How is the times-interest-earned ratio calculated, and what does it evaluate?

Step-by-Step Solution

Answer

The times-interest-earned ratio is the ratio between earnings before interest & tax (EBIT)  and interest expense. 

Step 1: Times-interest-earned ratio

Times-interest-earned is a kind of ratio that evaluates a business’s ability to pay interest expenses. It is also called the interest coverage ratio. A high coverage ratio indicates the easiness to pay interest and a low ratio indicates difficulty.

Step 2: Calculation and interpretation of the ratio

The interest coverage ratio is calculated by dividing the EBIT by the interest expense. EBIT is the earnings before making any deductions regarding interest and tax. So EBIT represents the amount that is available for disbursement of any interest expense. Tax liability arises after paying interest.  

 

So, the times-interest ratio indicates the available earnings multiples of interest expense. It compares the earnings before interest and tax times of interest expense.

$\mathrm{Times}-\mathrm{interest}-\mathrm{earned}=\frac{\mathrm{EBIT}\left(\mathrm{Net} \mathrm{income}+\mathrm{Income} \mathrm{tax}+\mathrm{Interest}\right)}{\mathrm{Interest} \mathrm{expense}}$