How to Determine Whether the Company Can Pay Its Obligations

by Daria Kelly Uhlig Google

Interest expenses for outstanding obligations such as loans, bonds and other long-term liabilities are considered fixed expenses -- expenses that don't change much over time. Although your small business benefits from these liabilities because they increase cash flow, fixed expenses also create risk. Downward fluctuations in your company's earnings before interest and tax -- its operating income -- can leave it unable to pay its obligations. Assess the risk of default by determining the company's times interest earned ratio, also referred to as its interest coverage ratio. The lower the ratio and the longer a low ratio is sustained, the greater the company's risk of default. Optimally, the ratio should stay above 1.5 to 2.

Prepare an income statement to determine your company's operating income. Begin with total revenue. Deduct from that the costs of the goods sold, salaries, rent, utilities and other operating expenses. For example, if sales totaled $50,000 and the cost of goods, salaries, rent and utilities each cost $5,000, for a total of $20,000 in expenses, the operating income is $30,000.

Total the company's interest expenses.

Divide the operating income by the interest expenses. For example, if the interest expenses are $10,000, divide the $30,000 operating income by $10,000 to arrive at a times interest expense ratio of 3.


  • The times interest earned ratio provides a current snapshot of a company's ability to pay its bills. It doesn't reflect future risk.
  • Income variability influences the level of risk a particular times interest earned ratio represents. Wide year-to-year income swings represent higher risk. Growing companies and companies with stable income can assume comparatively more debt.
  • Use the times interest earned ratio in concert with other accounting formulas for a more comprehensive financial evaluation.

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