Coverage Ratios and Times Interest Earned
Coverage ratios measure the ability of a business to service its debt. Banks and bondholders often use these ratios while performing “credit analysis.” A popular measure of coverage is the “Times Interest Earned” ratio or earnings before interest and taxes” ("EBIT") to interest:
Times Interest Earned = Pre-Tax Net Income + Interest Expense
Interest Expense
The times interest earned ratio measures the coverage of interest expense by profits. Income taxes are added back because taxes are calculated after interest is paid; in other words, these funds are (or would be) available to cover interest payments.
The ratio must exceed one to indicate coverage, and a higher ratio implies greater ability to service interest expense. For Smith Heating and Cooling, Inc., the ratio indicates coverage of 1.76 times.
Keep in mind that this ratio excludes principal payment requirements and that upcoming interest expense may not necessarily be the same as historical interest expense.
Times Interest Earned = Pre-Tax Net Income + Interest Expense
Interest Expense
The times interest earned ratio measures the coverage of interest expense by profits. Income taxes are added back because taxes are calculated after interest is paid; in other words, these funds are (or would be) available to cover interest payments.
The ratio must exceed one to indicate coverage, and a higher ratio implies greater ability to service interest expense. For Smith Heating and Cooling, Inc., the ratio indicates coverage of 1.76 times.
Keep in mind that this ratio excludes principal payment requirements and that upcoming interest expense may not necessarily be the same as historical interest expense.
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