Times Interest Earned Ratio

The times interest earned ratio indicates the firm's ability to meet its interest payments out of its annual operating earnings. JImco's ratio is computed as follows:

Times interest earned = net operating income (NOI)or earning before interest and taxes (EBIT)
annual interest expense
$4,000,000 = 4.00 times
$1,000,000

industry average = 7.62 times

This ratio is much lower than the industry norm of 7.62 times. However, it appears that Jimco's earnings could be improved in order to afford the higher use of financial leverage.

Cash Flow Overall Coverage Ratio

The purpose of this ratio is to compare the cash flow (from net operating income) available to meet fixed financial commitments against the cash requirements of these obligations.

Cash flow overall coverage ratio =

net operating income + lease expense + deprecation ------------------------------------ interest + lease expense +

preferred dividend/ (1 - combined corporate tax rate) + principal payments/

(1- combined corporate tax rate)

$(4,000,000 + 500,000) = ------------------------ 500,000 $1,000,000 + ----------- (1-0.40)

$4,500,000 = ----------- = 2.45 times $1,833,333

Thus, Jimco's operating earnings were 4.00 times its interest expense, whereas the firm's operating cash flows were only 2.45 times its total finance charges.


Summarizing the results of Jimco's leverage ratios, we have made two basic observations: (1) Jimco has utilized more nonowner financing than is characteristic of its industry; (2) Jimco's earnings could be improved in order to afford the higher use of financial leverage.


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Finance For Strategic Management
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