When providers of debt finance, such as banks, review a business plan financial projections, they are interested in a business’s ability to service and repay any loans made to it. One of the indicators they look for is whether the business will generate sufficient operating income to meet its interest payments on any loans provided. In order to do this they calculate the times interest earned ratio, sometimes referred to as the interest coverage ratio or simply interest cover.
The times interest earned formula can be stated as follows:
The operating income is what is left of the income after the business has paid all its operating expenses, this at the very least should be sufficient to pay the interest due on the borrowings of the business. Depreciation is added back in the calculation of operating income as it does not represent a cash related expense and so does not restrict a business’s ability to pay its interest charges.
How to Calculate Times Interest Earned
The numbers used to calculate the times interest earned ratio can all be found in the income statement of the business as shown in the example below.
|Cost of sales||135,000|
|Income before tax||63,000|
|Income tax expense||13,000|
In this example the times interest earned ratio is calculated as follows:
Times interest earned = (Operating income + Depreciation) / Interest Times interest earned = (78,000 + 12,000) / 15,000 = 6.00
The times interest earned ratio is a measure of the ability of a business to make interest payments on its debt, as such it is a measure of the credit worthiness of the business. In the above example, the ratio of 6.00 means that the interest to be paid on loans is covered 6.00 times by the operating income of the business.
From the lenders point of view the higher the times interest earned ratio the less risky the business is and the more they are reassured that their loans are reasonably secure. The lower the times interest earned ratio the more concerned the lender will be that the business may not be able to pay the interest charges, thereby reducing the chances of them providing any debt finance to the business.
There is no correct value for the times interest earned ratio as it depends on the industry in which the business operates but generally it should be greater than 2.5. It is useful to compare the calculated figure with other businesses in your industry using figures available from published financial statements. The times interest ratio should never be lower than 1 otherwise the business is not generating enough income to meet its interest obligations.
In the financial projections template, the times interest earned is indicated on the financial ratios page under the leverage ratios heading as the interest cover ratio.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.