Question

The times-interest-earned ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. a. True b. False

Answer 1

a. True. The times-interest-earned ratio measures a company's ability to cover interest costs with operating income, providing insight into its financial stability.

Step-by-step explanation:

The times-interest-earned (TIE) ratio is a financial metric used to assess a company's ability to cover its interest expenses with its operating income. The formula for calculating the TIE ratio is as follows:

`\[ TIE = (Operating~Income)/(Interest~Expense) \]`

A TIE ratio greater than 1 indicates that the company generates enough operating income to cover its interest costs. In other words, it measures the safety margin a company has to absorb a decline in operating income without defaulting on its interest payments. If the TIE ratio is less than 1, it suggests that the company may have difficulty meeting its interest obligations.

For example, if a company has an operating income of $500,000 and an interest expense of $100,000, the TIE ratio would be
`\( TIE = (500,000)/(100,000) = 5 \).` This means the company's operating income is five times its interest expense, indicating a comfortable margin of safety.

In summary, a true statement, the TIE ratio indeed measures the extent to which operating income can decline before a company is unable to meet its annual interest costs. It serves as a crucial financial indicator for creditors and investors assessing the risk associated with a company's debt obligations.