CP

and some provide the ratio of debt to equity, so be sure to check the source’s

definition.^6

Ability to Pay Interest: Times Interest Earned

The times-interest-earned (TIE) ratiois determined by dividing earnings before

interest and taxes (EBIT in Table 9-2) by the interest charges:

The TIE ratio measures the extent to which operating income can decline before the

firm is unable to meet its annual interest costs. Failure to meet this obligation can

bring legal action by the firm’s creditors, possibly resulting in bankruptcy. Note that

earnings before interest and taxes, rather than net income, is used in the numerator.

Because interest is paid with pre-tax dollars, the firm’s ability to pay current interest is

not affected by taxes.

MicroDrive’s interest is covered 3.2 times. Since the industry average is 6 times,

MicroDrive is covering its interest charges by a relatively low margin of safety. Thus,

the TIE ratio reinforces the conclusion from our analysis of the debt ratio that Micro-

Drive would face difficulties if it attempted to borrow additional funds.

Ability to Service Debt: EBITDA Coverage Ratio

The TIE ratio is useful for assessing a company’s ability to meet interest charges on its

debt, but this ratio has two shortcomings: (1) Interest is not the only fixed financial

charge—companies must also reduce debt on schedule, and many firms lease assets

and thus must make lease payments. If they fail to repay debt or meet lease payments,

they can be forced into bankruptcy. (2) EBIT does not represent all the cash flow

available to service debt, especially if a firm has high depreciation and/or amortization

charges. To account for these deficiencies, bankers and others have developed the

EBITDA coverage ratio,defined as follows:^7

Industry average
4.3 times.

$283.8$100$28

$88$20$28

$411.8

$136

3.0 times.

EBITDA coverage ratio

EBITDALease payments

InterestPrincipal paymentsLease payments

Industry average
6.0 times.

$283.8

$88

3.2 times.

Times-interest-earned (TIE) ratio

EBIT

Interest charges

382 CHAPTER 10 Analysis of Financial Statements

(^6) The debt-to-assets (D/A) and debt-to-equity (D/E) ratios are simply transformations of each other:
(^7) Different analysts define the EBITDA coverage ratio in different ways. For example, some would omit the
lease payment information, and others would “gross up” principal payments by dividing them by (1 T)
because these payments are not tax deductions, hence must be made with after-tax cash flows. We included
lease payments because, for many firms, they are quite important, and failing to make them can lead to
bankruptcy just as surely as can failure to make payments on “regular” debt. We did not gross up principal
payments because, if a company is in financial difficulty, its tax rate will probably be zero, hence the gross up
is not necessary whenever the ratio is really important.
D/E

D/A
1 D/A, and D/A

D/E
1 D/E.

378 Analysis of Financial Statements