CSLB Law & Business ExamBusiness FinancesHard
A contractor is analyzing the company's financial leverage. The times interest earned (TIE) ratio is calculated as Earnings Before Interest and Taxes (EBIT) divided by Interest Expense. If a company has an EBIT of $150,000 and interest expense of $30,000, what does a TIE ratio of 5 indicate?
- AThe company takes 5 days to collect its accounts receivable.
- BThe company's debt is 5 times its equity.
- CThe company can cover its interest expenses 5 times over.
- DThe company's net profit is 5% of its total revenue.
Show answer & explanationAnswer & explanation
Correct answer: C. The company can cover its interest expenses 5 times over.
The Times Interest Earned (TIE) ratio measures a company's ability to meet its debt obligations (interest payments). A TIE ratio of 5 means that the company's earnings before interest and taxes are 5 times greater than its interest expense, indicating a strong ability to cover its interest payments. $150,000 (EBIT) / $30,000 (Interest Expense) = 5.
Why the other options are wrong
- A. Incorrect. This describes the days sales outstanding or average collection period, not the TIE ratio.
- B. Incorrect. This describes the debt-to-equity ratio, not the TIE ratio.
- D. Incorrect. This describes a net profit margin, not the TIE ratio.
Times Interest Earned (TIE) Ratio
A solvency ratio that measures a company's ability to meet its debt obligations by indicating how many times the company's earnings before interest and taxes (EBIT) can cover its interest expenses.
- Formula: Earnings Before Interest and Taxes (EBIT) / Interest Expense.
- A higher ratio indicates better financial health and lower risk for lenders.
- Used to assess a company's capacity to service its debt.
Memory trick: Can you 'cover' your payments? That's the question.