Question

JBJ Antiques (JBJ) reported the following comparative income figures in 2006.

(in thousands)	2006	2005
Net Sales	701	646
Other income	10	8
	711	654
Cost and Expenses:
Cost of goods sold	472	408
Selling and general expenses	176	156
Interest	28	22
	676	586
Income before income tax and extraordinary item	35	68
Income taxes	(15)	(30)
Income before extraordinary items	20	38
Extraoridnary items- Loss on fire		18
Net Income	20	20

Your boss, the president of Henry Bank, is concerned about JBJs borrowing capacity. A representative of JBJ feels that there should be no problem, since net profits are the same with slightly higher sales.

Required: Compute times interest earned and comment on the bank's position.

Answer 1

Solution :Time interest ratio = EBIT ÷ Interest expense

Time interest ratio (2005) = $68 ÷ $22 = 3.09

Time interest ratio (2006)   = $35 / $28 =1.25

Time interest ratio used to measure the paying ability of business to its debts. If Time interest ratio is less than 1 that means business is not in a position to meet it's interest obligation. In other words, higher the ratio, higher the ability to meet debt obligations

In the given case, the Time interest ratio has substantialy decreased from 3.09 to 1.25 which shows the decreasing ability of the JBJ to pay it's debts. However,  a representative of JBJ feels that there should be no problem, since net profits are the same with slightly higher sales.

His view is not correct since, net profit is not relevent to the Time interest ratio.