Times Earned Interest is just what it says. It tells us how many times the company under our analysis can pay the interest expense on their debt. It is calculated by:
Ebit (operating income) / Interest Expense
Remember that companies often borrow money in order to expand their business, but as with all loans, they must repay them with the interest associated with that loan. This can greatly affect the bottom line of a company’s financial report and is watched by the banks (among many other things) in order to gauge risk.
If a company has high interest payments compared to their operating income, it tends to imply the company is in a highly competitive industry and must continue with borrowing and capital expenditures in order to stay competitive.
What types of numbers should we be looking for? First, it depends upon the industry and the companies you are researching, but as a general rule of thumb, anything less than 1.5 would indicate that a company was in danger of not being able to pay the interest on their loan and a number less than 1.0 could indicate that the company is headed toward bankruptcy. A TIE number less than 1.0 indicates the inability of the company to pay its interest that quarter, potentially requiring them to sell off some assets or somehow raise additional equity to fund that debt payment. It does not indicate that it will go bankrupt, but that the possibility exits. Recognize that if you see this, the banks that lend them the money see this. It is also important to recognize trends. You may note that some cyclical companies have times where they have negative numbers, but they turn positive in their strong months. Higher is better.
As an example, let’s look at OfficeMax (OMX) and their leading
competitor, Staples (SPLS):
Note the companies in the same industry have vastly different numbers. OfficeMax has reported a TIE
number of less than 1.0 twice in the last four quarters. Even in the quarters it had positive numbers,
they are very low based upon our “rule of thumb” of not being less than 1.5 and they are low in comparison with their main competitor. You may also note the trend of Staples interest expense decreasing. Staples is the obvious leader.
Investors can sometimes be lazy. A glance at some of OfficeMax’ other metrics, reveal a Quick Ratio of 1.1 and a Current Ratio of 1.9. Looking at those numbers, one might conclude that things were well in the short term and put the issue of debt behind them. Continue to poke and prod the numbers in front of you. There’s more than meets the eye.
Lennar Corp. (LEN), which indicates a Quick Ratio of 1.6 and a Current Ratio of 4.9, does not fare well with its TIE metric for the last four quarters. Certainly, one must remember the cyclical nature of the industry and the bad times the housing industry is facing. These numbers may improve, but ignore them at your own risk.
Bank of America (BAC) is currently making interest payments just under 98% of their operating income for the trailing twelve months.
Another easy way to recognize danger is to use the charts so easily available at GuruFocus. Take Alcoa as an example. The trend line for operating income is headed downward and the trend line for interest expense is headed upward. This should cause you to pause and do further research.
Be careful and happy investing!
Disclosure: Long on Staples (SPLS)