Final answer:
The times interest earned ratio indicates how many times a company can cover its interest payments with its pre-tax earnings, helping investors and creditors to assess the company's financial stability and credit risk.
Step-by-step explanation:
The times interest earned ratio, also known as the interest coverage ratio, provides crucial information to investors and creditors about a company's ability to meet its interest obligations. This ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expenses. It reflects how many times a company can cover its interest payments with its pre-tax earnings, which is a strong indicator of financial stability.
For investors, it represents the company's risk premium and allows them to gauge the safety margin a company possesses in paying interest expenses which, in turn, influences the expected rate of return. Creditors use this ratio to assess the likelihood that the company can continue to pay its debts, and therefore, is key in evaluating the firm's credit risk. A higher ratio suggests a more comfortable financial position, whereas a low ratio could indicate a higher chance of default, similar to issuing high yield bonds or junk bonds.