A times interest earned ratio of 0.20 to 1 means 1. That the firm will default on its interest payment. 2. That net income is less than the interest expense (including capitalized interest). 3. That cash flow exceeds the net income. 4. That the firm should reduce its debt. 5. None of the above.
The correct answer and explanation is:
Correct Answer: 1. That the firm will default on its interest payment.
Explanation:
The Times Interest Earned (TIE) ratio is a key financial metric that evaluates a company’s ability to meet its interest obligations. It is calculated using the formula: TIE Ratio=Earnings Before Interest and Taxes (EBIT)Interest Expense\text{TIE Ratio} = \frac{\text{Earnings Before Interest and Taxes (EBIT)}}{\text{Interest Expense}}
A TIE ratio of 0.20 to 1 means that the company’s EBIT is only 20% of its interest expense. In other words, the firm is generating insufficient income to cover even a fraction of its interest obligations.
Why this indicates a potential default:
- Insufficient Earnings: The company’s operating earnings (EBIT) are not enough to cover its interest expenses, signaling that the firm cannot meet its debt obligations through operational income.
- Liquidity Crisis: If the firm consistently earns less than what it owes in interest, it may deplete cash reserves or rely on external funding sources, such as additional borrowing, which could worsen its financial position.
- Creditor Concerns: A TIE ratio below 1.0 typically raises red flags for creditors and investors, as it suggests that the firm is at high risk of defaulting on its interest payments.
Why the other options are incorrect:
- 2: A low TIE ratio does not directly indicate that net income is less than interest expense, as net income accounts for taxes and non-operating items.
- 3: The TIE ratio does not compare cash flow and net income.
- 4: While reducing debt may improve the TIE ratio, the ratio itself does not directly recommend action.
- 5: The ratio provides a clear indication of financial stress, making this incorrect.
In conclusion, a TIE ratio of 0.20 to 1 strongly suggests that the firm is likely to default on its interest payments unless corrective actions are taken promptly.