11 - 11 Times-interest-earned(TIE ratio Aa Aa The...

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Unformatted text preview: 11. Times-interest-earned (TIE) ratio Aa Aa The times-interest-earned (TIE) ratio shows how well a firm can cover its interest payments with operating income. Compare the income statements of Hackworth Co. and Initech Corp. and calculate the TIE ratio for each firm. Hackworth Co. Initech Corp. Income Statement Income Statement For the Year Ended on December 31 For the Year Ended on December 31 (Millions of dollars) (Mllllons of dollars) Net Sales $700 Net Sales $500 Variable costs 280 Variable costs 125 Fixed costs 245 Fixed costs 225 Total Operating Costs $525 Total Operating Costs $350 Operating Income (or EBIT) 175 Operating Income (or EBIT) 150 Less interest 50 Less interest 80 Earnings before Taxes (EBT) $125 Earnings before Taxes (EBT) $70 Less taxes (40%) 50 Less taxes (40%) 28 Net Income $75 Net Income $42 Times Interest Earned (TIE) Times Interest Earned (TIE) Complete the following statement, based on the calculations you have already made. Describe the relationship between the TIE ratios of the two companies. I O Hackworth Co. has a greater TIE ratio than Initech Corp.. 0 The companies have equal TIE ratios. 0 Initech Corp. has a greater TIE ratio than Hackworth Co.. Which company is in better position to cover its interest payments, and therefore exhibits lower risk, than the other? 0 Both companies are equally positioned to cover their interest payments. 0 Initech Corp. is in a better position to cover its interest payment. v/ Q Hackworth Co. is in a better position to cover its interest payment. Explanation: Close A Compute the TIE ratio by dividing the EBIT by the interest expense: EBIT TIE = — Interest Expense Hackworth Co. Initech Corp. $175 $150 TIE = 7 TIE = 7 $50 $80 1.88 3.50 Hackworth Co.'s TIE ratio of 3.50 is greater than Initech Corp.'s 1.88 ratio. As a result, Hackworth is in a better position to cover its interest payments and exhibits less risk than Initech. This makes sense because with Hackworth’s earnings are 3.50 times its interest expense and, therefore, are sufficient to cover its interest expense 3.50 times. In contrast, Initech’s earnings are only 1.88 times its interest charges and so can cover its interest expense only 1.88 times. Analysts will interpret this as causing Initech to exhibit greater risk than Hackworth. In general, when a firm’s TIE ratio is high, its earnings, compared to its interest obligation, are high. Conversely, if its TIE ratio is low, then the number of times a firm can pay interest with earnings is low. In this case, there is an increased chance that a firm may not be able to pay its debts and will be forced into bankruptcy. A TIE ratio of less than 1 is an indication that a firm does not have sufficient earnings to cover its interest payments. Even if the firm does not have to declare bankruptcy, most debt contracts stipulate that the firm maintain a TIE ratio at some minimum level in order to borrow additional funds. ...
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