Times Interest Earned Ratio (TIER), also known as the Interest Coverage Ratio, measures the ability of the enterprise to meet its financial obligations (interest payments on debt due). The formula for TIER is as follows:
TIER = EBIT/interest charges
EBIT refers to earnings before interest and taxes, which is also called operating profit (refer to the format of an income statement to see how it is calculated).
Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The TIER of ABC is as follows:
It is generally advisable that the Times Interest Earned Ratio should be between 3 and 5.
ABC’s TIER could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk taken may be lower than average, but so is the return.
Things to note about this ratio
When using the TIER , it is important to remember that interest is paid with cash and not with income (since some income may still be in the form of accounts receivable). Therefore, the real ability of the firm to make interest payments may be worse than indicated by the TIER. It is also important to remember that debt obligations include repayment of principal debt as well as payment of interest.
One should compare debt ratios of individual firms to industry averages, to obtain a better understanding. There is a large variability of debt ratios’ industry averages between industries. This is because different industries have different operations requirements.