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When a company borrows money to finance its operations, it must pay interest on those loans so the lender can make a profit on the transaction. The more money a company makes, the more comfortably it can handle those interest payments. The Times Interest Earned Ratio calculates the number of times a company could pays its yearly interest bill based on its earnings before interest and taxes. To calculate a company's Times Interest Earned Ratio, you divide Earnings Before Interest and Taxes or EBIT by the interest paid for the year. So, in this worksheet I have Earnings Before Interest and Taxes, Interest, and also Taxes.
Even though we don't use the Taxes figure in this formula, you'll usually find it on a worksheet or in an annual report along with the Interest and the EBIT, Earnings Before Interest and Taxes. But you don't need to worry. It's not used in the formula. To calculate the Times Interest Earned Ratio, you divide the Earnings Before Interest and Taxes by the interest that's due in a given year. So, to that you divide B5, the EBIT, by Interest, and press Return, and there is your result. This company makes six times the money it needs to pay its interest every year, which indicates a healthy earning power and that it's a no danger of defaulting on any of its loans.
Now, even though it might seem prudent to keep a company's Times Interest Earned Ratio as high as possible, an extremely high ratio might indicate that a company either has not taken on enough debt to pursue new opportunities, or that it is paying down its current debt too quickly, using funds that could be invested elsewhere. By contrast, a low Times Interest Earned Ratio won't be a problem for a company with a lot of cash in the bank, but the closer the ratio gets to 1, the more likely it is that company will run into problems. Potential lenders can use the Times Interest Earned Ratio to evaluate a company's creditworthiness, and potential investors can use the number to determine whether a company is managing its debt load effectively.
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