In this article, I’m gonna show you how to calculate times interest earned which is also known as the interest coverage ratio. Let’s say a company had earnings before interest in taxes (EBIT) of $500 and they had interest expense of $100 that company’s times interest earned ratio would be 5, Which is just $500 divided by $100 and the bigger the interest earned ratio is the better the company is able to make its interest payments.
Now there are a couple of different ways that analysts would go about calculating times interest earned, One way is just to take a company’s net income and then add back interest expense and income tax expense and then divide by interest expense.
Another way is to take a company’s operating profit and then divide it by interest expense. You might be thinking these are very similar but actually they are close but bear in mind that by adding net income in the 2nd formula, non-operating revenues are gonna be included in the numerator here, and then in the 3rd method you do not include any non-operating revenues.
Let me show you an example so let’s take a look at Netflix at their actual financial statements and we’ll calculate their times interest earned, we’ll do it for 2018 for the fiscal year ended December 31st 2018. So we’re gonna calculate it each way and I’m gonna show you how it’s different.
If we take the net income + the interest expense + the tax expense, We’ve got so these numbers are in thousands so we’ve got a little over 1.2 billion dollars of net income for Netflix in 2018 but then we’re gonna add back the interest expense that 420 million dollars of interest expense is gonna get added back and then we’ve gone income tax expense of a little over 15 million. So we’ve got 15 million dollars here of income tax expense that’s our numerator. We’ll call this option number one way of calculating this then we’re going to divide by the interest expense which again we’ve already calculated. If you do that you get to a times interest earned ratio of 3.9.
Now the other way of doing it would be to look in the numerator operating profit, operating income which is about 1.6 billion dollars. So if we do it that way we take the 1.6 billion and then divide by interest expense you’re gonna get a slightly different number you’re gonna get 3.8 – and why is there a difference here?
Well, notice the operating income does not only include interest expense or the income tax expense but it also doesn’t include this non-operating revenue. The company had some interest revenue which is a non-operating item so it’s not including that this isn’t being factored in when we do option number two.
These are just two different ways to calculate this, every analyst is gonna have their own way that they prefer to calculate certain ratios for example an analyst might even say “Well, look what I want to do instead of using 420 million dollars of interest expense in the denominator maybe they would like to do option 2 where they’ve got the operating profit in the numerator but then in the denominator under option 2 maybe they say well I’m gonna take interest expense and I’m gonna offset it by the interest revenue”. So then it would be less than 420 million because of 420 million dollars of interest expense for Netflix in 2018 but they had 41 million dollars of interest revenue. So you could actually net those two together that’s just another way of doing it. Again every analyst is going to have their own specific way that they like to compute the ratio.