Companies sell bonds to borrow money and must pay interest to bondholders in exchange for the use of the borrowed funds. If a company proves unable to meet its interest payments on bonds and other debt obligations, it may be forced to declare bankruptcy. The number of times the bond and other debt interest charges are earned each year is called the times interest earned ratio or interest coverage ratio. This ratio indicates how likely it is a company will be able to meet its interest obligations.
1. Look for the company’s operating income listed on its annual income statement. Operating income is the money the company earned after expenses but before interest and taxes are paid. You can find the income statement in the company’s annual report. Many companies let you download their annual reports from their investor relations websites. Alternatively, you can order a copy of the annual report from your broker or the company.
2. Locate the amount of bond interest paid, which is listed below operating income on the income statement. Look to see if the company also paid interest on notes or other debts. If that is the case, add this additional interest to the bond interest paid.
3. Divide the operating income by the total interest paid to calculate the times interest earned ratio. The higher the ratio, the better able the company is to make its interest payments. Suppose a company has operating income of $3 million and interest payments on bonds and other debts totaling $500,000. Divide $3 million by $500,000. The times interest earned ratio is six. This means the company earned enough operating income to pay its interest obligations six times over a one year period.
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