Chapter 7 Long Term Debt Paying Ability Solutions

CHAPTER 7LONG-TERM DEBT-PAYING
ABILITY
MULTIPLE CHOICE
1. Jones Company has long-term debt of $1,000,000, while Smith Company, Jones' competitor, has long-
term debt of $200,000. hich of the following statements best represents an analysis of the long-term
debt position of these two firms!
a
.
Smith Company's times interest earned sho"ld be lower than Jones.
b
.
Jones ob#io"sly has too m"ch debt when compared to its competitor.
c
.
Jones sho"ld sell more stoc$ and "se less debt.
d
.
Smith has fi#e times better long-term borrowing ability than Jones.
e
.
%ot eno"gh information to determine if any of the answers are correct.
&%S' (
2. )ngram *og +ennels had the following financial statistics for 2010'
,ong-term debt $400,000
-a#erage rate of interest is ./0
)nterest e1pense 35,000
%et income 48,000
)ncome ta1 46,000
2perating income 107,000
hat is the times interest earned for 2010!
a
.
11.3 times
b
.
4.4 times
c
.
4.1 times
d
.
4.5 times
e
.
none of the answers are correct
&%S' *
4. & times interest earned ratio of 0.60 to 1 means'
a
.
that the firm will defa"lt on its interest payment
b
.
that net income is less than the interest e1pense
5-1
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c
.
that the cash flow is less than the net income
d
.
that the cash flow e1ceeds the net income
e
.
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3. hich of the following will not ca"se times interest earned to drop! &ss"me no other changes than
those listed.
a
.
&n increase in bonds payable with no change in operating income.
b
.
&n increase in interest rates.
c
.
& rise in preferred stoc$ di#idends.
d
.
& rise in cost of goods sold with no change in interest e1pense.
e
.
& drop in sales with no change in interest e1pense.
&%S' C
5-2
=. & times interest earned ratio indicates that'
a
.
preferred stoc$ has no mat"rity date
b
.
the debt will ne#er become d"e
c
.
the firm will be able to repay the principal when d"e
d
.
the principal can be refinanced
e
.
&%S' (
>. Jordan ;an"fact"ring reports the following capital str"ct"re'
C"rrent liabilities $100,000
,ong-term debt 400,000
*eferred income ta1es 10,000
?referred stoc$ 80,000
Common stoc$ 100,000
?remi"m on common stoc$ 180,000
8etained earnings 170,000
hat is the debt ratio!
a
.
0.3.
b
.
0.36
c
.
0.64
d
.
0.6>
e
.
&%S' <
5. 9he debt ratio indicates'
a
.
the ability of the firm to pay its c"rrent obligations
b
.
the efficiency of the "se of total assets
c
.
the magnification of earnings ca"sed by le#erage
d
.
a comparison of liabilities with total assets
e
.
5-4
&%S' *
5-3
.. Joseph and John, )nc., had the following balance sheet res"lts
for 2010'
-in millions0
C"rrent liabilities $12.6
<onds payable 18.6
,ease obligations 2.7
;inority interest 1.4
Common stoc$ 8.6
8etained earnings 22.9
$66.8
Comp"te the debt-e@"ity ratio.
a
.
112.1/
b
.
.5.>/
c
.
>5.>/
d
.
3>.5/
e
.
&%S' &
6. hich of the following statements best compares long-term borrowing capacity ratios!
a
.
9he debtAe@"ity ratio is more conser#ati#e than the debt ratio.
b
.
9he debt ratio is more conser#ati#e than the debtAe@"ity ratio.
c
.
9he debtAe@"ity ratio is more conser#ati#e than the debt to tangible net worth ratio.
d
.
9he debt to tangible net worth ratio is more conser#ati#e than the debtAe@"ity ratio.
e
.
9he debt ratio is more conser#ati#e than the debt to tangible net worth ratio.
&%S' *
10. )n comp"ting debt to tangible net worth, which of the following is not s"btracted in the denominator!
a
.
Copyrights
b
.
Boodwill
c
.
?atents
d
.
)n#estments
e 9rademar$s
5-=
.
&%S' *
11. & fi1ed charge co#erage'
a
.
is a balance sheet indication of debt carrying ability
b
.
is an income statement indication of debt carrying ability
c
.
is a li@"idity ratio
d
.
fre@"ently incl"des research and de#elopment
e
.
comp"tation is standard from firm to firm
&%S' <
5->
12. 9he following financial statement data are ta$en from Ceron
Company's 2010 ann"al report'
-in millions0
C"rrent assets $12.6
)n#estments 9.4
)ntangibles 6.8
9angible assets -net0 58.1
C"rrent liabilities 6.4
,ong-term debt 39.7
Stoc$holders' e@"ity 40.8
Comp"te the debt ratio.
a
.
16>.6/
b
.
114.0/
c
.
=4.0/
d
.
3=.5/
e
.
&%S' C
14. 9he following financial statement data are ta$en from Ceron Company's 2010 ann"al report'
-in millions0
C"rrent assets $12.6
)n#estments 9.4
)ntangibles 6.8
9angible assets -net0 58.1
C"rrent liabilities 6.4
,ong-term debt 39.7
Stoc$holders' e@"ity 40.8
Comp"te the debt to tangible net worth ratio.
a
.
13>../
b
.
14=.>/
c
.
=4.0/
d
.
3=.5/
e
.
&%S' <
5-5
13. )f a firm has s"bstantial capital or financing leases disclosed in the notes b"t not capitaliDed in the
financial statements, then'
a
.
the times interest earned ratio will be o#erstated, based "pon the financial statements
b
.
the fi1ed charge ratio will be o#erstated, based "pon the financial statements
c
.
the debt ratio will be "nderstated
d
.
the wor$ing capital will be "nderstated
e
.
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5-.
1=. :nder the (mployee 8etirement )ncome Sec"rity &ct, a
company can be liable for its pension plan "p to'
a
.
40 percent of its total assets
b
.
40 percent of its net worth
c
.
30 percent of its total assets
d
.
30 percent of its net worth
e
.
=0 percent of its total assets
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1>. )ncl"ded in the (mployee 8etirement )ncome Sec"rity &ct are the following'
a
.
pro#isions re@"iring minim"m f"nding of pension plans
b
.
minim"m rights to employees "pon termination of their employment
c
.
creation of the ?ension <enefit B"aranty Corporation
d
.
pro#isions re@"iring minim"m f"nding of pension plans and minim"m rights to
employees "pon termination of their employment
e
.
pro#isions re@"iring minim"m f"nding of pension plans, minim"m rights to employees
"pon termination of their employment, and creation of the ?ension <enefit B"aranty
Corporation
&%S' (
15. hat significant impro#ement in the financial reporting of pensions ha#e pension acco"nting r"les
pro#ided!
a
.
determination of the e1pense for the income statement
b
.
limited balance sheet recognition of pension liabilities
c
.
impro#ed disclos"re
d
.
determination of the e1pense for the income statement and limited balance sheet
recognition of pension liabilities
e
.
determination of the e1pense for the income statement, limited balance sheet recognition
of pension liabilities, and impro#ed disclos"re
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1.. 9here are a n"mber of ass"mptions abo"t f"t"re e#ents that m"st be made regarding a defined benefit
plan. &n ass"mption that does not need to be made is'
a
.
interest rates
5-6
b
.
employee t"rno#er
c
.
mortality rates
d
.
compensation
e
.
how long the firm will contin"e
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5-10
16. hich of the following statements is not correct!
a
.
& ratio that indicates a firm's long-term, debt-paying ability from the income statement
#iew is the times interest earned.
b
.
Some of the items on the income statement that are e1cl"ded in order to comp"te times
interest earned are interest e1pense, income ta1es, and "n"s"al or infre@"ent items.
c
.
CapitaliDed interest sho"ld be incl"ded with interest e1pense when comp"ting times
interest earned.
d
.
:s"ally, the highest times interest co#erage in the most recent fi#e-year period is "sed as
the primary indication of the interest co#erage.
e
.
)n the short r"n, a firm can often meet its interest obligations, e#en when the times
interest earned is less than 1.00.
&%S' *
20. hich of these items represents a definite commitment to pay o"t f"nds in the f"t"re!
a
.
bonds payable
b
.
reser#es for reb"ilding f"rnaces
c
.
deferred ta1es
d
.
minority shareholders' interests
e
.
redeemable preferred stoc$
&%S' &
21. hich of the following statements is not tr"e relating to a capitaliDed -capital0 lease!
a
.
& capital lease is handled as if the lessee bo"ght the asset.
b
.
9he leased asset is in the fi1ed assets and the related obligation is incl"ded in liabilities.
c
.
2n the balance sheet, the capitaliDed asset amo"nt will not "s"ally agree with the
capitaliDed liability amo"nt beca"se the liability is red"ced by payments, and the asset is
red"ced by depreciation ta$en.
d
.
:s"ally, a company depreciates capitaliDed leases faster than payments are made.
e
.
2n the balance sheet, the capitaliDed asset amo"nt will "s"ally be higher than the
capitaliDed liability amo"nt.
&%S' (
22. hich of the following statements is not tr"e relating to a defined contrib"tion pension plan!
a
.
& defined contrib"tion plan defines the contrib"tions of the company to the pension plan.
b
.
2nce the defined contrib"tion is paid, the company has no f"rther obligation to the
pension plan.
c
.
9his type of plan shifts the ris$ to the employee as to whether the pension plan will grow
to pro#ide for a reasonable pension payment "pon retirement.
d
.
9here is no problem estimating the company's pension e1pense.
5-11
e
.
9his type of plan presents s"bstantial problems in
estimating the pension liability.
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24. & n"mber of ass"mptions abo"t f"t"re e#ents m"st be made regarding a defined benefit plan. hich of
the following does not represent one of the ass"mptions!
a
.
interest rates
b
.
termination date for the firm
c
.
employee t"rno#er
d
.
mortality rates
e
.
compensation
&%S' <
TRUE/FALSE
1. hen analyDing a firm's long-term, debt-paying ability, we only want to determine the firm's ability to
pay the principal.
&%S' E
2. )n general, the profitability of a firm is not considered to be important in determining the short-term,
debt-paying ability of the firm.
&%S' 9
4. & good times interest earned record wo"ld be indicated by a relati#ely high, stable co#erage for the
times interest earned co#erage.
&%S' 9
3. ;inority shareholders' interest in earnings of s"bsidiaries are incl"ded in earnings for the times interest
earned co#erage.
&%S' 9
=. (@"ity earnings are e1cl"ded from earnings for the times interest earned co#erage.
&%S' 9
>. CapitaliDed interest sho"ld not be considered as part of interest in the times interest earned
comp"tation.
&%S' E
5-12
5. 9o get a better indication of a firm's ability to co#er interest
payments in the long r"n, the noncash charges for depreciation, depletion, and amortiDation can be
added bac$ to the times interest earned ratio.
&%S' E
.. hen a portion of operating lease payments is incl"ded in fi1ed charges, it is an effort to recogniDe the
tr"e total interest that the firm is paying.
&%S' 9
6. :nder generally accepted acco"nting principles, an item m"st clearly represent a commitment to pay
o"t f"nds in the f"t"re in order to be classified as a liability.
&%S' 9
10. hen a firm is e1pensing an item faster on the ta1 ret"rn than on the financial statements, a deferred
ta1 liability is the res"lt.
&%S' 9
11. &s with the debt ratio and the debtAe@"ity ratio, from a long-term, debt-paying ability #iew, the lower
the debt to tangible net worth ratio, the better.
&%S' 9
12. 9he debt to tangible net worth ratio is a more conser#ati#e ratio than the debt ratio.
&%S' 9
14. & Foint #ent"re can add significant potential liabilities to the parent company that are not on the face of
the balance sheet.
&%S' 9
13. & potential significant liability is possible if the company withdraws from a m"lti-employer pension
plan.
&%S' 9
1=. & defined benefit plan shifts the ris$ to the employee as to whether the pension f"nds will grow to
pro#ide for a reasonable pension payment "pon retirement.
&%S' E
1>. )f an employee is in the pension plan, rights "nder this plan will be lost if the employee lea#es the firm
prior to recei#ing a #ested interest.
&%S' 9
5-14
15. 9he balance sheet pension liability considers the proFected
benefit obligation.
&%S' E
1.. Some companies achie#e benefits by h"ndreds of millions of dollars by a pension termination.
&%S' 9
16. 9imes interest earned indicates a firm's long-term, debt-paying ability from the balance sheet #iew.
&%S' E
20. CapitaliDation of interest res"lts in interest being added to a fi1ed asset instead of e1pensed.
&%S' 9
21. )n the short r"n, a firm can often meet its interest obligations e#en when the times interest earned is
less than 1.00.
&%S' 9
5-13
22. 9he ta1 e1pense for the financial statements often agrees with
the ta1es payable.
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24. Some re#en"e and e1pense items ne#er go on the ta1 ret"rn, b"t do go on the income statement.
&%S' 9
23. 8epayment of a long-term ban$ loan wo"ld decrease the debt ratio.
&%S' 9
2=. )ncreases of profits by c"tting the cost of sales wo"ld increase the times interest earned.
&%S' 9
PROBLEMS
1. ,a"ra <ella Company reports the following statement of income'
2perating 8e#en"es $4,800
Costs and (1penses'
Cost of Sales (2,000)
Selling, Ser#ice, &dministrati#e, and Beneral (1pense (1,500)
)ncome <efore )nterest (1pense and )ncome 9a1es $1,300
)nterest (1pense (180)
)ncome <efore )ncome 9a1es $1,120
)ncome 9a1es (350)
%et )ncome $ 770
%ote' *epreciation e1pense totals $400G preferred di#idends total $>0G operating lease payments total
$1.0. &ss"me that 1A4 of operating lease payments is for interest.
8e@"ired'
a
.
Comp"te the times interest earned.
b
.
Comp"te the fi1ed charge co#erage.
&%S'
a.
8ec"rring (arnings <efore
)nterest (1pense, 9a1,
9imes )nterest (arned H ;inority )ncome and (@"ity (arnings
)nterest (1pense, )ncl"ding
CapitaliDed )nterest
)ncome before income ta1es $1,120
5-1=
?l"s interest 180
&dF"sted income $1,300 (A)
)nterest e1pense $ 180 (B)
-&0 $1,400A-<0 $1.0 H 5.22 times
b.
8ec"rring (arnings
<efore )nterest
(1pense, 9a1, ;inority
)ncome
and (@"ity (arnings
Ei1ed Charge
Co#erage H
I )nterest ?ortion of
8entals
)nterest (1pense,
)ncl"ding
CapitaliDed )nterest I
)nterest
?ortion of 8entals
)ncome before income ta1es $1,120
?l"s interest 180
&dF"sted income $1,300
1A4 of operating lease payments
-1A4 $1.00 60
$1,360
)nterest e1pense $180
1A4 of operating lease payments 60
$240
Ei1ed charge co#erage H $1,4>0 H =.>5 times
$230
5-1>
2. 9he following information is comp"ted from East Eood
ChainJs ann"al report for 2010.
2010 2006
C"rrent assets
$ 2,731,02
0 $ 2,364,916
?roperty and e@"ipment, net 10,960,286 8,516,833
)ntangible assets, at cost
less applicable amortiDation
294,77
5
255,91
9
$13,986,08
1 $11,137,668
C"rrent liabilities
$ 3,168,12
3 $ 2,210,735
*eferred federal income ta1es 160,000 26,000
;ortgage note payable 456,000
Stoc$holders' e@"ity
10,201,95
8
8,900,93
3
$13,986,08
1 $11,137,668
%et sales
$33,410,59
9 $25,804,285
Cost of goods sold
(30,168,71
5)
(23,159,745
)
Selling and administrati#e e1pense
(2,000,000
) (1,500,000)
)nterest e1pense (216,936) (39,456)
)ncome ta1 e1pense
(400,00
0)
(300,000
)
%et income
$ 624,94
8 $ 805,084
%ote' 2ne-third of the operating lease rental charge was $100,000 in 2010 and $=0,000 in
2006. CapitaliDed interest totaled $40,000 in 2010 and $20,000 in 2006.
8e@"ired'
a
.
<ased on the abo#e data for both years, comp"te'
1
.
times interest earned
2
.
fi1ed charge
4
.
debt ratio
3
.
debtAe@"ity ratio
=
.
debt to tangible net worth
b
.
Comment on the firm's long-term borrowing ability based on the analysis.
5-15
5-1.
&%S'
a.
1.
;inority
)ncome and (@"ity (arnings
9imes )nterest (arned
H
201
0
2006
%et Sales
$
33,410,599
$25,80
4,285
,ess Cost of Boods Sold
(30,168,71
5)
23,15
9,745)
Selling and
&dministrati#e
(2,000,0
00)
(1,50
0,000)
-&0
$
1,241,884
$
1,144,
540
)nterest (1pense
$
216,936
$
39,456
30,00
0

20,000
9otal )nterest -<0
$
246,936
$
59,456
-&0A-<0
5.03 times
19.25
times
8ec"rring (arnings
<efore
;inority
(arnings, (@"ity
(arnings, ?l"s
2 Ei1ed
Charge
)nterest H
)nterest ?ortion of
8entals
)nterest (1pense,
)ncl"ding
CapitaliDed )nterest,
?l"s
)nterest ?ortion of
8entals
2010 2006
Erom ?art -10
$1,241
,884
$1,144
,540
)nterest ?ortion of 8entals
10
0,000
50
,000
5-16
-&0
$1,341
,884
$1,194
,540
Erom ?art -10
$
246,93
6
$
59,456
)nterest ?ortion of 8entals
100
,000
50
,000
-<0
$ 346
,936
$
109,4
56
-
&
0A
-
<
0
3
.87 times
10.91
times
4. *ebt 8atio H 9otal ,iabilities
9otal &ssets
$4,5.3,124 $2,24>,54=
$14,6.>,0.1 $11,145,>>.
25.1/ 20.1/
5-20
3. *ebtA(@"ity 8atio H
9otal ,iabilities
Stoc$holders' (@"ity
$4,5.3,124 $2,24>,54=
$10,201,6=. .,600,644
45.1/ 2=.1/
=. *ebt to 9angible %et
orth H
9otal ,iabilities
Stoc$holders' (@"ity - )ntangibles
$4,5.3,124 H 4..2/ $2,24>,54= H 2=.6/
$10,201,6=. - $263,55= $.,600,644 - $2==,616
b
.
)n 2010, this firm had a s"bstantial rise in debt. 9his incl"ded c"rrent liabilities, deferred
ta1es, and a new mortgage note payable. 9his increased debt and the related increased
interest e1pense ca"sed a decline in interest co#erage and a rise in the debt, debtAe@"ity,
and debt to tangible net worth ratios. )n addition, operating lease rental charges went "p,
which lowered the fi1ed charge co#erage.
4. 9he following financial information is e1cerpted from the 2010 ann"al report of 8etail ?rod"cts, )nc.
<alance Sheet
-in tho"sands0
2010 2006
C"rrent assets
$
449,195
$
433,049
)n#estments 32,822 55,072
*eferred charges 4,905 12,769
?roperty, plant, and e@"ipment, net 350,921 403,128
9rademar$s and leaseholds 45,031 47,004
(1cess of cost o#er fair mar$et
#al"e of net assets ac@"ired 272,146 276,639
&ssets held for disposal
6,06
2
10,2
47
$ 1,161,082 $1,237,908
9otal liabilities
$
689,535
$
721,149
9otal stoc$holders' e@"ity
471,547
516,75
9
$ 1,161,082 $1,237,908
)ncome Statement
%et sales $ 2,020,526 $1,841,738
Cost of goods sold
(2,018,436)
(1,787,126
)
5-21
Selling and
administrati#e (300,000) (250,000)
)nterest e1pense
(40,000
)
(30,000
)
%et income -loss0
$ (337,910
)
$ (225,388
)
5-22
8e@"ired'
Eor each year comp"te'
a. 1. 9imes interest earned
2. *ebt ratio
4. *ebtAe@"ity ratio
3. *ebt to tangible net worth ratio
b. Comment on the res"lts.
c
.
*oes a times interest earned ratio of less than 1 to 1 mean that the firm cannot pay its
interest e1pense!
&%S'
a
.
)nterest, 9a1, ;inority )ncome
1
.
9imes )nterest (arned H and (@"ity (arnings
2010
$2,020,=2> - $2,01.,34> - $400,000
$30,000
%egati#e 5.3= 9imes
2006
$1,.31,54. - $1,5.5,12> - $2=0,000
$40,000
%egati#e >.=1 9imes
2
.
*ebt 8atio
H
9otal
,iabilities
9otal &ssets
2010 2006
$>.6,=4= $521,136
$1,1>1,0.
2
$1,245,60
.
=6.3/ =..4/
4 *ebtA(@"
ity 8atio
H
9otal
,iabilities
9otal
Stoc$holders'
5-24
(@"ity

2010

2006
$>.6,=4= $521,13
6
$351,=35 $=1>,5=
6
13>.2/ 146.>/
5-23
3
.
*ebt to 9angible H
9otal ,iabilities
%et worth 8atio 9otal Stoc$holders' (@"ity -
)ntangible &ssets
2010
$>.6,=4= H 33>.5/
$351,=35 - $3=,041 - $252,13>
2006
$521,136 H 454.3/
$=1>,5=6 - $35,003 - $25>,>46
b
.
9his firm has had a rise in the debt, debtAe@"ity, and debt to tangible net worth ratios. 9he
debt to tangible net worth is especially high d"e to the high amo"nt of e1cess of cost o#er
fair mar$et #al"e of net assets.
9he times interest earned fig"re dropped from a negati#e >.=1 times in 2006 to a negati#e
5.3= times in 2010.
9his firm's long-term borrowing ability appears to be #ery negati#e and deteriorated f"rther
in 2010.
c
.
%o, a times interest earned ratio of less than 1 to 1 does not mean, in the short r"n, that the
firm cannot meet its interest payments. Some of the e1penses, s"ch as depreciation, do not
re@"ire c"rrent f"nds, b"t they do red"ce the interest co#erage. &lso, in the short r"n, the
o"tlay can come from so"rces of f"nds other than income.
3. ;r. Jones has as$ed yo" to ad#ise him of the long-term debt position of *ryden Corporation. Ke
pro#ides yo" with the ratios indicated below.
200. 2006 2010
Ei1ed Charge Co#erage 6.3 4.5 5.0
9imes )nterest (arned 8.2 6.0 5.3
*ebt 8atio 40% 39% 40%
*ebt to 9angible %et orth 80% 81% 84%
8e@"ired'
Bi#e the implications and limitations of each item separately and then the collecti#e inference one may
draw abo"t *ryden's long-term, debt-paying ability.
5-2=
&%S'
9imes interest earned has declined. 9his can be ca"sed by lower income, higher debt, or a combination
of both.
Ei1ed charge co#erage has declined. 9he decline for this ratio has been less than the decline in the
times interest earned. 9his indicates that the "se of noncapitaliDed leases has declined.
9he debt ratio is relati#ely stable.
9he debt to tangible net worth ratio has increased slightly. 9his can be ca"sed by higher debt, lower
e@"ity, or higher intangibles.
Since the debt ratio is relati#ely constant, the problem does
not appear to be higher debt. 8ather, higher interest rates or lower income appear to be the problem.
Since the debt ratio is constant, the most logical e1planation for the rise in debt to tangible net worth is
a rise in intangibles, which lowers the denominator.
9he long-term debt position has declined, b"t we need more information abo"t the company and
ind"stry in order to come to a concl"sion on the long-term debt position.
=. &msterdam &nti@"es reported the following comparati#e income fig"res in 2010.
-in
tho"sands0
2010 2006
%et sales $701 $646
2ther income
10

8
$711 $654
Costs and e1penses'
Cost of goods sold $472 $408
Selling and general e1penses 176 156
)nterest 28 22
$676 $586
)ncome before income ta1es and e1traordinary items
$
35
$
68
)ncome ta1es
(15
)
(30
)
)ncome before e1traordinary items
$
20
$
38
(1traordinary itemsLlosses from fire 18
%et income
$
20
$
20
Mo"r boss, the president of &msterdam ban$, is concerned abo"t &msterdam's borrowing capacity. &
representati#e of &msterdam &nti@"es feels that there sho"ld be no problem, since net income are the
same with slightly higher sales.
8e@"ired'
Comp"te times interest earned and comment on the ban$'s position.
5-2>
&%S'
)nterest, 9a1, ;inority
9imes )nterest (arned H )ncome and (@"ity (arnings
2010 2006
)ncome before income ta1es and e1traordinary items $ 35 $ 68
?l"s interest e1pense 28 22
-a0 $ 63 $ 90
-b0 )nterest e1pense $ 28 $ 22
-a0 N -b0 2.25 times 4.09 times
9he ability of the firm to co#er its interest has declined s"bstantially d"e both to rising interest and
falling income.
9he statement by the &msterdam &nti@"es representati#e is false. 9he only reason that net income was
at $20,000 in 2006 was beca"se of the e1traordinary fire loss. 8ec"rring profits dropped from $4.,000
to $20,000.
>. 8e@"ired'
Eollowing is a list of paired ratios and transactions. Eor each transaction, indicate the effect of that
transaction on the specific ratio. :se I for increase, - for decrease, and 0 for no effect.
9ransaction 8atio
a
.
& firm is re@"ired to capitaliDe leases
pre#io"sly presented only in notes.
*ebt 8atio of 0.3
b
.
& firm sells its own common stoc$. *ebtA(@"ity 8atio of 1.12
c
.
& firm has an increase in selling e1pense with
no change in other e1penses.
9imes )nterest (arned 8atio of >.2 to 1
d
.
& firm writes off a siDeable acco"nt
recei#able.
9imes )nterest (arned 8atio of 4.> to 1
e
.
& firm pays cash for a #al"able patent. *ebt to 9angible %et orth 8atio of 1.4
to 1
&%S'
a
.
I
b
.
-
c -
5-25
.
d
.
0
e
.
I
5-2.
5. &ristocrats &rt reported the following trend analysis to its
ban$ as an attachment to a loan application.
2010 2006 200.
Ei1ed Charge 8atio 4.00 2.50 1.54
9imes )nterest (arned 8atio 4.94 3.17 2.08
*ebt 8atio 0.47 0.51 0.56
*ebt to 9angible %et orth 8atio 0.91 1.06 1.36
Mo" ha#e been as$ed to e#al"ate the long-term borrowing capacity. Mo" $now that a r"le of th"mb for
this ind"stry for the debtA e@"ity ratio is 1 to 1.
8e@"ired'
a
.
Comp"te the debtAe@"ity ratio for 2010, 2006, and 200., "sing the debt ratio as a g"ide.
b
.
Comment on the long-term borrowing ability of this firm.
&%S'
a )f total liabilities are .35 of total
assets, then total stoc$holders'
e@"ity m"st be .=4, since total
liabilities pl"s total stoc$holders'
e@"ity H total assets.
*ebt H 0.35 H ..6 -20100
(@"ity 0.=4
0.=1 H 1.03 -20060
0.36
0.=> H 1.25 -200.0
0.33
b
.
9his firm shows e#idence of an impro#ed, long-term borrowing capacity position. 9he
times interest earned ratio and the fi1ed charge ratio has impro#ed, as has the debt ratio,
debt to tangible net worth ratio, and debtAe@"ity ratio. 9he debtAe@"ity ratio is now below
the ind"stry a#erage.
5-26
.. Mo" ha#e been as$ed to e#al"ate the long-term borrowing
position of Client, )nc. Kowe#er, yo" were gi#en only the following limited information.
<onds payable, 12/ $1,000,000
Stoc$holders' e@"ity 1,800,000
C"rrent assets 1,870,000
9angible assets, net 1,600,000
)ntangible assets 40,000
)n#estments 120,000
2ther assets 90,000
Sales 4,000,000
2perating e1penses 3,620,000
8e@"ired'
&ss"ming that this is the only information yo" will recei#e, estimate the following ratios'
a
.
9imes interest earned ratio
b
.
*ebt ratio
c
.
*ebtAe@"ity ratio
d
.
*ebt to tangible net worth ratio
&%S'
Comp"tations for fig"res needed in the ratios follow.
9otal assets'
C"rrent assets $1,870,000
9angible assets 1,600,000
)ntangible assets 40,000
)n#estments 120,000
2ther assets 90,000
9otal assets $3,720,000
,iabilities'
9otal assets $3,720,000
,ess stoc$holders' e@"ity 1,800,000
9otal liabilities $1,920,000
)nterest'
$1,000,000 0.12 H $120,000
)nterest, 9a1 ;inority )ncome
a 9imes )nterest (arned H and (@"ity (arnings
5-40
. 8atio
H $3,000,000 -
$4,>20,000
H
4.15
$120,000 time
s
b
.
*ebt 8atio H 9otal ,iabilities
9otal &ssets
H $1,620,000 H =1.>/
$4,520,000
c
.
*ebtA(@"ity 8atio H 9otal ,iabilities
Shareholder' (@"ity
H $1,620,000 H
10>.5/
$1,.00,000
d
.
*ebt to 9angible H 9otal ,iabilities
%et orth 8atio Shareholders' (@"ity - )ntangible
&ssets
H $1,620,000 H
106.1/
$1,.00,000 -
$30,000
6. 8e@"ired'
)ndicate the effect of each of the following transactions on the ratios listed. :se I to indicate an
increase, - to indicate a decrease, and 0 to indicate no effect. &ss"me an initial times interest earned
ratio of 4 to 1, debt ratio of 0.= to 1, debtAe@"ity ratio of 1.0 to 1, and total debt to tangible net worth
ratio of 1.1 to 1.
9imes *ebt 9otal *ebt
)nterest *ebt (@"ity 9angible
%et
9ransaction (arned 8atio 8atio orth
5-41
8atio 8atio
a
.
Collection of acco"nts recei#able.
b
.
Eirm has decreasing profits d"e to rising cost
of sales.
c
.
Eirm appropriates a s"bstantial amo"nt for
e1pansion.
d
.
Con#ersion of preferred stoc$ to common.
e
.
8epayment of a short-term ban$ loan -ignore
interest0.
f. ?ayment for a #al"able trademar$.
g
.
9he stoc$ is split two for one.
h
.
?"rchase of e@"ipment financed by a long-
term note -consider interest0.
i. Con#ersion of bonds to stoc$.
F. *eclaration and payment of di#idend.
$
.
9he firm e1periences a rise in the rate
charged on its line of credit.
5-42
&%S'
9imes *ebt 9otal *ebt
)nterest *ebt (@"ity 9angible
%et
9ransaction (arned
8atio
8atio 8atio orth
8atio
a
.
Collection of acco"nts recei#able. 0 0 0 0
b
.
Eirm has decreasing profits d"e to rising cost
of sales.
- - - -
c
.
Eirm appropriates a s"bstantial amo"nt for
e1pansion.
0 0 0 0
d
.
Con#ersion of preferred stoc$ to common. 0 0 0 0
e
.
8epayment of a short-term ban$ loan -ignore
interest0.
0 - - -
f. ?ayment for a #al"able trademar$. 0 0 0 I
g
.
9he stoc$ is split two for one. 0 0 0 0
h
.
?"rchase of e@"ipment financed by a long-
term note -consider interest0.
- I I I
i. Con#ersion of bonds to stoc$. I - - -
F. *eclaration and payment of di#idend. 0 I I I
$
.
9he firm e1periences a rise in the rate
charged on its line of credit.
- I I I
5-44
10. ,isted below are se#eral ratios.
a. times interest earned
b. fi1ed charge co#erage
c. debt ratio
d. debtAe@"ity ratio
e. debt to tangible net worth
8e@"ired'
;atch the letter that goes with each form"la.
OOO
OO
1.
9otal ,iabilities
Shareholders' (@"ity -
)ntangible &ssets
OOOOO 2. 9otal ,iabilities
9otal &ssets
8ec"rring (arnings,
(1cl"ding
)nterest (1pense, 9a1
(1pense,
OOO
OO
4.
(@"ity (arnings, and
;inority (1pense
8ec"rring (arnings,
(1cl"ding
)nterest (1pense, 9a1
(1pense,
(@"ity (arnings, and
;inority (arnings
OOO
OO
3.
I )nterest ?ortion of
8entals
)nterest (1pense, incl"ding
CapitaliDed )nterest I
)nterest
?ortion of 8entals
OOOOO =. 9otal ,iabilities
Shareholders' (@"ity
&%S'
1
.
e
5-43
2
.
c
4
.
a
3
.
b
=
.
d
5-4=

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