COMPUTE THE TIMES INTEREST EARNED RATIO AND USE IT TO ANALYZE LIABILITIES.

Interest expense is often called a fixed expense because it usually does not vary due to short$-$term changes in sales or other operating activities. While fixed expenses can be good when a company is growing, they create risk. The risk is that a company might be unable to pay fixed expenses if sales decline. Consider Diego Co$.\text{'}$s results for $2021$ and two possible outcomes for year $2022$ in L Exhibit $11\mathrm{.}6.$ Expenses excluding interest are expected to remain at $75\%$ of sales. Expenses that change with sales volume are variable expenses. Interest expense is fixed at $$60$ per year.

EXHIBIT $11\mathrm{.}6$ Actual and Projected Results

$2022$ Projections

$2021$ Sales Increase Sales Decrease

$ millions $$600$ $$900$ $$300$

Sales Expenses $(75\%$ of sales$)450675225$

Income before interest $15022575$

Interest expense $($tixed$)606060$

Net income $ $90$ $$165$ $ $15$

The Sales Increase column of L Exhibit $11\mathrm{.}6$ shows that Diego's net income increases by $83\%$ to $$165$ if sales increase by $50\%$ to $$900.$ The Sales Decrease column shows that net income decreases by $83\%$ if sales decline by $50\%.$ These results show that the amount of fixed interest expense affects a company's risk of its ability to pay interest. One measure of "ability to pay" is the times interest earned ratio in ~ Exhibit $11\mathrm{.}7.$

EXHIBIT $11\mathrm{.}7$

Times Interest Earned Times interest earned $=$ income before interest expense and income taxes $/$Interest expense

For $2021,$ Diego's times interest earned is computed as $$150/$$$60,$ or $2\mathrm{.}5$ times. This ratio means that Diego has low to moderate risk because its sales must decline sharply before it is unable to pay its interest expenses. If times interest earned falls below around $1\mathrm{.}5,$ a company will likely be at risk of not being able to pay its liabilities.