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Ratios: Times Interest Earned (TIE) quiz #1 Flashcards

Ratios: Times Interest Earned (TIE) quiz #1
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  • What is the Times Interest Earned (TIE) ratio and what does it measure?
    The Times Interest Earned (TIE) ratio is a solvency ratio that measures how many times a company can cover its interest expense with its operating income, indicating its ability to meet interest obligations.
  • How is the Times Interest Earned (TIE) ratio commonly calculated?
    The TIE ratio is commonly calculated as operating income divided by interest expense.
  • What is an alternative formula for calculating the Times Interest Earned (TIE) ratio?
    An alternative formula is: (Net income + Interest expense + Income tax expense) divided by interest expense.
  • Why is operating income used in the TIE ratio calculation?
    Operating income is used because it reflects income from core business activities, excluding non-operating expenses like interest and taxes.
  • What does a higher Times Interest Earned (TIE) ratio indicate about a company’s financial health?
    A higher TIE ratio indicates better solvency, meaning the company can comfortably meet its interest obligations multiple times over.
  • Why might banks require a minimum TIE ratio in loan agreements?
    Banks require a minimum TIE ratio to ensure the company can consistently cover its interest payments, reducing the risk of loan default.
  • What could happen if a company fails to maintain the required TIE ratio specified in a loan agreement?
    If a company fails to maintain the required TIE ratio, it could default on the loan, potentially making the entire loan due immediately.
  • What does it mean if a company’s TIE ratio is less than 1?
    A TIE ratio less than 1 means the company’s operating income is insufficient to cover its interest expense, indicating financial distress.
  • Which expenses are typically excluded from operating income when calculating the TIE ratio?
    Interest expense and income tax expense are typically excluded from operating income when calculating the TIE ratio.
  • How does the TIE ratio help assess a company’s solvency?
    The TIE ratio helps assess solvency by showing how many times a company can pay its interest expense from its core operating income.
  • If a company has an operating income of $150,000 and interest expense of $50,000, what is its TIE ratio?
    The TIE ratio is 3.0 ($150,000 ÷ $50,000).
  • Why is it important for a company to have a TIE ratio significantly higher than 1?
    A TIE ratio significantly higher than 1 provides a cushion against fluctuations in income, reducing the risk of being unable to pay interest.
  • What does the 'x' in a TIE ratio (e.g., 3x) represent?
    The 'x' represents how many times the company’s operating income covers its interest expense.
  • How often do banks typically check a company’s TIE ratio when a loan agreement is in place?
    Banks regularly check a company’s TIE ratio, often at each financial reporting period, to ensure compliance with loan agreements.
  • What is the significance of adding back interest and income tax expenses to net income in the alternative TIE calculation?
    Adding back interest and income tax expenses to net income adjusts for non-operating items, effectively returning to operating income for the TIE calculation.
  • How does the TIE ratio relate to a company’s risk of financial distress?
    A low TIE ratio increases the risk of financial distress, as the company may struggle to meet its interest payments from operating income.