• Calculate the times interest earned ratio

 

The final “gearing” or “leverage” ratio is commonly called times interest earned.

[latex]\dfrac{\text{net income before tax}+\text{interest expense}}{\text{interest expense}}[/latex]

Jonick Company
Comparative Income Statement
For the Years Ended December 31, 2019 and 2018

Description	2019
Subcategory, Other revenue and expenses
Gain on sale of investments	$137,000
Interest expense	(55,000)
	Single Line
Income before income tax	$314,000
Income tax expense	66,000
Net income	Single Line$248,000 Double Line

For Jonick, net income before tax (NIBT) + interest expense is $314,000 + $55,000 = $369,000. That represents the amount of accrual basis income available to pay interest and taxes and to provide a profit for the business (and by extension, the owners).

Since interest expense had been deducted in arriving at income before income tax on the income statement, it is added back in the calculation of the ratio.

Dividing that amount by the amount of interest expense gives a factor that indicates how much income is available to pay interest on borrowed funds. Let’s do the calculations:

[latex]\dfrac{\$314,000+\$55,000}{\$55,000}=\dfrac{369,000}{55,000}=6.7090909…\approx6.71[/latex]

In other words, Jonick, in 2019, earned, before taxes, 6.7 times the amount of interest incurred.

The number of times anything is earned is always more favorable when it is higher since it impacts the margin of safety and the ability to pay as earnings fluctuate, particularly if they decline.

As with all these metrics, as an investor or owner, or manager, you could devise variations. For instance, a similar ratio could be applied to preferred dividends by dividing net income by preferred dividends in order to monitor the company’s ability to pay those dividends.

[latex]\dfrac{\text{net income}}{\text{preferred dividends}}[/latex]

For example: [latex]\dfrac{248,000}{12,000}=20.7[/latex]