When it comes to determining whether or not an investment is a smart one, there are many different factors to look out for. For example, you may want to read a variety of reports about a certain company’s stock performance, or you could be interested in learning more about the stock by looking closely at a few historical graphs. If you’re starting to do some alternative investing, you may need more data to base your decision on, particularly if you’re considering making an investment in a newer business.
One factor to pay attention to when evaluating start-ups and other young companies is a factor known as the times interest earned ratio. Sometimes referred to as the TIE ratio, this number can help you better understand a company’s finances and how much risk they pose to you as an investor. Here’s more information about the TIE ratio, including what it means if a company has a negative TIE ratio.
What is the TIE ratio?
Put in its simplest terms, the TIE ratio is a measure of both riskiness and solvency. It can help inform you about a company’s earning and debt obligations, two factors which can ultimately contribute to a company’s demise if mismanaged. While strong earnings obviously make any company look good on paper, the TIE ratio gets one step deeper, evaluating if those earnings are enough to cover the business’ outstanding debts. Keep in mind that many start-ups require loans or credit accounts with interest rates in order to get the ball rolling. As such, having a TIE ratio to help you evaluate a company can give you a fuller picture of how they’re truly performing beyond an income statement.
How is the TIE ratio calculated?
Calculating the TIE ratio is actually quite simple and only involves a little bit of addition and division. First, you start by adding together the business’s earnings before interest and taxes, also known as EBIT. This gives you an idea of how much net income a business has. From there, you’ll want to divide that total by the total amount of interest that’s payable on any business debt and other interest obligations. That will give you a numerical value that stands for the number of times a company can cover all of its interest expenses with its total income.
What are some examples of good and bad TIE ratios?
Obviously, if the value of a TIE ratio ultimately signifies the number of times a business can pay its debt obligations, a higher number is generally preferred. That’s because if the value is only one, it can mean that the company you’re interested in investing in can only just barely afford to repay its debts. A number of less than one is even worse, signifying significant risk in how a company’s finances are being handled. Thus, a negative ratio is a clear sign that the company is facing some serious financial hardship and could be a strong indicator of a company that is close to bankruptcy.
A good TIE ratio is generally considered to be a number of five or higher since that illustrates that the business in question has more than enough money to handle the full amount of interest expenses they’ve incurred. It is important to note, however, that the higher ratio doesn’t always mean that things are being managed properly. For example, a business with a much higher ratio than the industry average could be mismanaging its debts by not paying them off aggressively enough. As such, if something seems out of the ordinary, even if it’s a positive sign, it could be worth looking at additional financial statements before making an investment.