What is the Times Interest Earned ratio and why is it important for a small business like A Touch of Tuscany?
The Times Interest Earned Ratio is an excellent profitability ratio and also one of the most common ratio that is used by lenders when making business loans. The Times Interest Earned Ratio is arrived at by dividing the Operating Income by the Interest expenses faced the small business on all its debt obligations. Thus the Times Interest Earned Ratio measures the ability of the small business to cover its interest cost from its operations.
As we can see from the definition that the higher the Times Interest Earned ratio the better it is for a small business like A Touch of Tuscany. Lenders and potential partners are most interested in seeing if the small business will be able to pay them back on the investment they have made in the small business. If they see that the operations of the business is able to generate enough operating income to pay the interest expenses comfortably, they will be much more inclined to lend the business capital.
In many instances the Times Interest Earned Ratio is also defined as the Earnings Before Interest & Taxes (EBIT) divided by the Annual Interest Expenses of the small business.
Does a declining Times Interest Earned Expense Ratio indicate that a small business owner like Jack Gordon could be headed for trouble?
Yes. Since the Times Interest Earned Expense Ratio is calculated by dividing the Operating Income by the annual interest expenses, it can start declining either because the Operating Income of a small business like A Touch of Tuscany has started slowing down or if the annual interest expenses have gone up. A small business owner like Jack Gordon will have to conduct further analysis to understand the cause of the decline in the Times Interest Earned Expense ratio and make strategic and tactical decisions accordingly.
For example if further analysis reveals that the Times Interest Earned Expense ratio is declining due to an decline in the operating income then a small business owner like Jack Gordon will need to understand why the operating income is declining. It could be due to an increase in the cost of goods sold which could be due to an increase in the cost of a particular input - here Jack Gordon may consider looking into getting a new supplier for the inputs that make up the cost of goods sold to keep them contained.
Operating expenses could have also gone up with the hiring of new people and expansion into new offices - these costs will no doubt increase the operating expenses and reduce the operating income. Sometimes a small business has to eat the upfront additional operating expenses to be able to generate a higher operating income later on downstream. However if after making the appropriate investment in operating expenses the small business does not see a commensurate return then Jack Gordon may have to consider cutting back his operating expenses to bring them back in line so that the Times Interest Coverage Ratio remains in line with the past.
If further analysis reveals that the Times Interest Earned ratio is declining due to an increase in the Annual Interest Expenses being faced by the small business then it may well be due to an increase in the rates of each or all of the business loans and lines; it could also be because a small business like A Touch of Tuscany has gone and taken on more debt or decided to draw down more of its business loans and lines to facilitate the expansion of the business resulting in a higher interest expense.
If this ratio starts declining a lot due to the added annual interest expenses being faced by the company the small business owner may well consider contributing some equity instead of only using debt as an instrument for the small business expansion plans. After all you don't want to loose out on your business loans and lines and that is exactly what will happen if you don't have enough of a cushion to cover your interest costs.
Does having a healthy Times Interest Earned Ratio give a small business owner like Jack Gordon an advantage over the competition?
Yes. If a small business like A Touch of Tuscany has a better Times Interest Earned ratio compared to its competition it means that it is able to cover its annual interest costs much better than the competition and that is always a good thing. Having a larger cushion to cover the interest expense means that a small business like A Touch of Tuscany will be able to ride out the tougher economic times in better shape than the competition.
Thus when things slow down, chances are that other businesses will start falling behind on their business loans and notes and that will of course negatively affect their business credit ratings as well as the personal credit scores of the small business owners that own the businesses. This will affect them a lot in the days ahead as they look to raise more capital. This is how small businesses go out of business.
On the other hand a small business like A Touch of Tuscany having a more comfortable cushion with a higher Times Interest Earned Ratio will be able to to ride out the tough times, and even raise more capital relatively easily and take advantage of the weakness of its competitors.
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