The interest expense for a company is equal to its earnings before interest and taxes (EBIT). The company’s tax rate is 40%. The company’s times interest earned ratio is equal to A. 2.0 B. 1.0 C. 0.6 D. 1.2
The Correct Answer and Explanation is:
Correct Answer: B. 1.0
Explanation:
The Times Interest Earned (TIE) ratio is a measure of a company’s ability to meet its interest obligations from its operating earnings. It is calculated using the following formula:TIE=EBITInterest Expense\text{TIE} = \frac{\text{EBIT}}{\text{Interest Expense}}TIE=Interest ExpenseEBIT
In this case, the question states that:Interest Expense=EBIT\text{Interest Expense} = \text{EBIT}Interest Expense=EBIT
So plugging that into the formula:TIE=EBITEBIT=1.0\text{TIE} = \frac{\text{EBIT}}{\text{EBIT}} = 1.0TIE=EBITEBIT=1.0
Thus, the company earns exactly enough from operations (before interest and taxes) to cover its interest obligations. This means it is just breaking even in terms of interest coverage.
Why the Tax Rate is Irrelevant Here:
Although the company’s tax rate is given as 40 percent, this information does not affect the calculation. The reason is that the TIE ratio uses EBIT, which is earnings before interest and taxes. The tax rate would be relevant for net income calculations but not for this ratio.
What a TIE of 1.0 Means:
A TIE ratio of 1.0 suggests the company is barely able to cover its interest payments. This is considered a red flag for lenders and investors, as any decline in earnings could make it difficult for the company to service its debt. Financially strong companies usually have TIE ratios well above 1.0, often in the range of 3.0 or higher.
Therefore, option B is the correct choice, and this low ratio indicates the company may be at high financial risk if its earnings drop.
