Times Interest Earned Ratio: Formula & Analysis

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  • 0:04 Time Interest Earned Ratio
  • 0:45 Interest Rates and Risk
  • 1:45 Calculation and Analysis
  • 2:40 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll discuss times interest earned and calculate and analyze the ratio. You'll also learn the relationship between interest rates and risk.

Times Interest Earned Ratio

Let's pretend you are the senior loan officer of a bank. A financial executive of a successful electronics superstore is seeking a business loan to purchase inventory and expand their location. To determine if you'll approve their loan, you'll need to analyze their risk of repaying the loan and calculate and analyze their times interest earned ratio.

Times interest earned is defined as what proportion of income is used to cover interest expense. It's calculated by taking income before interest and taxes divided by interest expense. Now let's take a deeper look at the times interest earned ratio and the relationship between interest rates and risk.

Interest Rates and Risk

A bank or financial institution must charge a business interest; they must get something in return for loaning money. Interest is defined as the cost of loaning money. Since interest on the loan may be paid over a number of years, analyzing risk is important.

When the bank receives a loan application, they analyze the riskiness of paying the money back. Some questions they consider are:

  • Will they be able to pay the money back?
  • What is the total dollar amount of outstanding loans?
  • Do they make their current loan payments on time?
  • What are their yearly sales?

Based on the answers, the bank determines the company's risk level in loaning the money. If the company has a good track record of payments and has sufficient income to repay the loan, the bank will apply a small interest rate to the loan. However, if the bank believes the company may have trouble repaying the loan, the bank will require a larger interest rate, thus a larger interest payment. Sometimes they may even decline the loan if they believe the risk is too great.

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