188
Chapter 7
Long-Term Debt-Paying Ability
QUESTIONS
7- 1. Yes, profitability is important to a firm’s long-term, debt– paying ability.
ability of the entity to meet its long-run obligations, the major emphasis when
entity.
7- 2. (1) Income statement.
(2) Balance sheet
to those provided by owners of the firm. If a high proportion of the resources
have been provided by outsiders, then this indicates that the risks of the
business have been shifted to outsiders.
7- 3. A relatively high, stable coverage of interest over the years is desirable. A
7- 4. No. The auto manufacturing business is known for its cyclical nature. The
funds from debt.
7- 5. A telephone company has its rate of return and, therefore, profits controlled by
financing.
7- 6. A firm must pay for the interest capitalized; therefore, this interest should be
189
7- 7. To get a better indication of a firm’s ability to cover interest payments in the
indication of the firm’s ability to cover interest.
7- 8. The financial statements are predominately prepared based upon historical
7- 9. No, the determination of the current value of the long-term assets is very
7-10. The intent of this ratio is to indicate the percentage of the assets that were
be less than or more than their liquidation value.
7-11. No, the debt ratio would not be as high as the debt/equity ratio because the
both the liabilities and the shareholders’ equity.
7-12. The balance sheet equation has assets = liabilities + shareholders’ equity.
Given any set of figures that agree with the basic balance sheet equation, the
equity.
For example, assets ($100,000) = liabilities ($40,000) + shareholders’ equity
($60,000).
7-13. Industry averages tend to indicate the degree of debt that is considered to be
acceptable for an industry. The industry average does not necessarily indicate
190
average for the debt ratio is 40% and the company’s debt ratio is 30% then
7-14. Operating leases simply require recording rent expense in the income
asset had been acquired with a loan.
7-15. If a firm has not capitalized its leases, then its debt ratios will be lower than
on the income statement, only rent expense. These two factors overstate the
debt position.
7-16. When capital leases are not capitalized then there will be less interest
earned ratio.
7-17. Pension claims have the status of tax liens, which gives them senior claim
over other creditors.
7-18. When an employee is vested in the pension plan, he/she is eligible to receive
vesting time.
7-19. Under the Employee Retirement Income Security Act, a contributor to a
7-20. An operating lease for a relatively long term is a type of long-term financing.
paying.
7-21. The Employee Retirement Income Security Act contains a feature that a
claim over other creditors.
7-22. Short-term funds in total become part of the total sources of outside funds in
191
sources of funds to total assets, and short-term funds are not a valid part of
conservative.
7-23. The bond payable account would represent a definite commitment that must
rebuilding furnaces, this will be at the discretion of management. The reserve
7-24. The specific assets that caused the deferred tax will likely be replaced by
and this view indicates that the deferred tax amount may not result in actual
relation to the assets being expensed.
7-25. This tentatively indicates that this firm has higher risk in terms of paying
industry.
7-26. This would indicate an increase in risk as management will more frequently be
7-27. This statement would be correct. . A guarantee of a loan is a type of
balance sheet.
7-28. True. Significant potential liabilities may be described in the contingency note.
liability has been incurred.
7-29. Instead of having a potential additional liability from a pension plan, the plan
192
7-30. Most firms must accrue or set a reserve for postretirement benefits other than
pensions. Firms can usually spread the catch-up accrual costs over twenty
7-31 Concentration of credit risk (lack of diversification) is perceived as indicative of
concentration.
7-32. Off-balance-sheet means that the risk has not been recorded. There is a
face of the balance sheet.
7-33. The disclosure of the fair value of financial instruments could possibly indicate
significant opportunity or additional risk to the company.
PROBLEMS
PROBLEM 7-1
Times Interest Earned
=
Recurring Earnings, Excluding Interest Expense, Tax
Expense, Equity Earnings, and Minority Earnings
Interest Expense, Including Capitalized Interest
Earnings before interest and tax:
Net sales
$
1,079,143
Cost of sales
(792,755)
Selling and administration
(264,566)
$
21,822
a.
Times Interest Earned
=
$21,822
=
5.06 times per year
$4,311
b. Cash basis times interest earned:
$21,822 + $40,000
=
$61,822
=
14.34 times per year
$4,311
$4,311
PROBLEM 7-2
a.
Times Interest Earned
=
Recurring Earnings, Excluding Interest Expense, Tax
Expense, Equity Earnings, and Minority Earnings
Interest Expense, Including Capitalized Interest
Income before income taxes
$
675
Plus interest
60
Adjusted income
$
735
Interest expense
$
60
$735
Adjusted income from part (a)
$
735
1/3 of operating lease payments (1/3 x $150)
50
Adjusted income, including rentals
$
785
Interest expense
$
60
1/3 of operating lease payments
50
$785
$110
a.
Times Interest Earned
194
Income before income taxes and extraordinary charges
$
36
Plus interest
16
(1) Adjusted income
52
(2) Interest expense
$
16
Times Interest Earned: (1) divided by (2) = 3.25 times per year
b.
Fixed Charge Coverage
=
Recurring Earnings, Excluding Interest Expense, Tax
Expense, Equity Earnings, and Minority Earnings +
Interest Portion of Rentals
Interest Expense, Including Capitalized Interest +
Interest Portion of Rentals
Adjusted income from part (a)
$
52
1/3 of operating lease payments (1/3 x $150)
50
(1) Adjusted income, including rentals
$
102
Interest expense
$
16
1/3 of operating lease payments
50
(2) Adjusted interest expense
$
66
PROBLEM 7-4
a.
Debt Ratio
=
Total Liabilities
=
$174,979
=
41.2%
Total Assets
$424,201
b.
Debt/Equity Ratio
=
Total Liabilities
=
$174,979
=
70.2%
Stockholders’ Equity
$249,222
c. Ratio of Total Debt to Tangible Net Worth =
Total Liabilities
=
$174,979
=
$174,979
=
70.9%
Tangible Net Worth
$249,222 – $2,324
$246,898
d. Kaufman Company has financed over 41% of its assets by the use of funds from
are over 70%. Whether these ratios are reasonable depends upon the stability of
earnings.
PROBLEM 7-5
Transaction
Times
Interest
Earned
Debt
Ratio
Debt/Equity
Ratio
Debt to
Tangible
Net Worth
a. Purchase of buildings financed by
mortgage
b. Purchase of inventory on short-
term loan at 1% over prime rate
c. Declaration and payment of cash
dividend
d. Declaration and payment of stock
dividend
e. Firm increases profits by cutting
cost of sales
f. Appropriation of retained earnings
g. Sale of common stock
–
–
0
0
+
0
0
+
+
+
0
–
0
–
+
+
+
0
–
0
–
+
+
+
0
–
0
–
196
PROBLEM 7-6
a. Times Interest Earned:
the improvement is an increase in profits.
proportion of the firm’s resources that have come from debt.
Debt Ratio:
The lower this ratio, the lower the proportion of assets that have been financed by
creditors.
For Arodex Company, this ratio has been steady for the past three years. This ratio
The debt ratio is limited in that it relates liabilities to the book value of total assets.
does not consider immediate profitability and, therefore, can be misleading as to
Debt to Tangible Net Worth:
The debt to tangible net worth relates total liabilities to shareholders’ equity less
conservative, in that book value is used for the assets and many assets have a
value greater than book value. The debt to tangible net worth ratio also does not
197
consider immediate profitability and, therefore, can be misleading as to the firm’s
ability to handle long-term debt.
to be reasonable and improving.
The stability of earnings and comparison with industry ratios will be important in
reaching a conclusion on the long-term debt position of Arodex Company.
Ratios provide only one aspect of a firm’s long-term debt-paying ability. Other
information, such as information about management and products, is also
important.
PROBLEM 7-7
a.
1.
Times Interest Earned
=
Recurring Earnings, Excluding Interest Expense, Tax
Expense, Equity Earnings, and Noncontrolling Interest
Interest Expense, Including Capitalized Interest
$162,000
=
8.1 times per year
$20,000
2.
Debt Ratio
=
Total Liabilities
Total Assets
$193,000
=
32.2%
$600,000