Chapter 4 Analysis of Financial Statements 95number of factors affect a company’s optimal debt ratio. Nevertheless, the fact
that Allied’s debt ratio exceeds the industry average by a fairly large amount
raises a red " ag, and this will make it relatively costly for Allied to borrow
additional funds without! rst raising more equity. Creditors will be reluctant to
lend the! rm more money, and management would probably be subjecting the
! rm to too high a risk of bankruptcy if it sought to borrow a substantial amount
of additional funds.^11
4-4b Times-Interest-Earned Ratio
The times-interest-earned (TIE) ratio is determined by dividing earnings before
interest and taxes (EBIT in Table 3-2) by the interest charges:
Times-interest-earned (TIE) ratio! __EBIT
Interest charges
! $283.8__
$88
! 3.2"
Industry average! 6.0"
The TIE ratio measures the extent to which operating income can decline before
the! rm is unable to meet its annual interest costs. Failure to pay interest will bring
legal action by the! rm’s creditors and probably result in bankruptcy. Note that
earnings before interest and taxes, rather than net income, is used in the numera-
tor. Because interest is paid with pretax dollars, the! rm’s ability to pay current
interest is not affected by taxes.
Allied’s interest is covered 3.2 times. The industry average is 6 times, so Allied
is covering its interest charges by a relatively low margin of safety. Thus, the TIE
ratio reinforces our conclusion from the debt ratio, namely, that Allied would face
dif! culties if it attempted to borrow much additional money.^12
Times-Interest-Earned
(TIE) Ratio
The ratio of earnings
before interest and taxes
(EBIT) to interest charges;
a measure of the firm’s
ability to meet its annual
interest payments.Times-Interest-Earned
(TIE) Ratio
The ratio of earnings
before interest and taxes
(EBIT) to interest charges;
a measure of the firm’s
ability to meet its annual
interest payments.(^11) The ratio of debt to equity is also used in! nancial analysis. The debt-to-assets (D/A) and debt-to-equity (D/E)
ratios are simply transformations of each other:
D/E! 1 "D/A D/A and D/A! 1 $D/E D/E
With a D/A ratio of 53%, or 0.53, Allied’s Debt/Equity ratio is 0.53/(1 – 0.53) = 1.13.
(^12) Another commonly used debt management ratio is the following:
EBITDA coverage!
EBITDA $ Lease payments
Interest ____$ Principal pa^ yments^ $ Lease pa^ yments^
This ratio is more complete than the TIE ratio in that it recognizes that depreciation and amortization expenses
are not cash charges and thus are available to service debt and that lease payments and principal repayments on
debt are! xed charges. For more on this ratio, see E. F. Brigham and P. R. Daves, Intermediate Financial Manage-
ment, 9th Edition, (Mason, OH: Thomson/South-Western, 2007), p. 258.
SEL
F^ TEST How does the use of! nancial leverage a" ect stockholders’ control position?
How does the U.S. tax structure in# uence a! rm’s willingness to! nance with
debt?
How does the decision to use debt involve a risk-versus-return trade-o"?
Explain the following statement: Analysts look at both balance sheet and in-
come statement ratios when appraising a! rm’s! nancial condition.
Name two ratios that are used to measure! nancial leverage and write their
equations.