Chapter # 7

Income Statement Consideration when determining Long-term Debt-

paying Ability
Times Interest Earned
• It indicates a firm’s long-term debt-paying ability from the income statement
view
• It this ratio is adequate, the firm can easily pay its interest obligations.
• If this ratio has good record, it can be able to refinance principal amount.
• The companies maintain the good record of this ratio, can finance relatively
high proportion of debt in relation to shareholders’ equity.
• They can obtain funds at favorable rates.
• The company issues debt obligations to obtain funds at an interest less than
the earnings from these funds. This is called trade on the equity or leverage.
• If the interest rate is high, the risk is that company cannot earn profits more
than cost of funds.
Time Interest Earned =
Recurring Earnings, excluding interest expense, tax expense, equity earnings, and minority Earnings
Interest Expense including capitalize d interest
• The following nonrecurring items should be excluded:
1. Discontinued operations
2. Extraordinary items
3. Cumulative effect of a change in accounting principle
The following should also be excluded:
1. Interest Expense
This added back to net income because the time interest earned will be
understated.
2. Income Tax Expense
If this item is deducted from net income, this is also be added back.
3. Equity earnings(losses) of nonconsolidated subsidiaries
These items should be excluded.
4. Minority Income (Loss)
All of the interest expense of the firm consolidated is included in the
consolidated income statement. Therefore, all of the income of the firm
consolidated should be considered in the coverage.
• The interest capitalized should be included with the total interest expense in
the denominator of the times interest earned ratio because it is part of the
interest payment.
 An example of capitalized interest would be interest during the
current year on a bond issued to build a factory.
• Capitalized interests are normally disclosed in a footnote and sometime on
the face of income statement.
• Computing interest earned for three to five years provides insight on the
stability of the interest coverage.
• Interest coverage on long-term debt is sometimes computed separately from
the normal times interest earned.
• In the long run, a firm must have the funds to meet all of its expenses but in
the short run, a firm can often meet its interest obligations even when the
times interest is less than 1.00.
Some of the expenses do not require funds in the short run.
 Depreciation expense
 Amortization expense
 Depletion expense
• To get the better indication of a firm’s ability to cover interest payments in
the short run, the non-cash expenses can be added back to the numerator of
the times interest ratio.
 • This ratio will be less conservative and it gives a cash basis times interest
earned useful for evaluating the firm in the short-run.

Fixed Charge Coverage

The fixed charge coverage ratio is an extension of the times interest earned ratio.
It is computed as follows:
Time Interest Earned =
Recurring Earnings, excluding interest exp., T exp., equity earnings, and minority Earnings +Interest Portion o
Interest Expense including capitalize d interest +Interest Portion of rentals

• A difference of opinion occurs in practice as to what should be included in the

fixed charges.
• The lessee treats a capital as an acquisition and includes the leased asset in
fixed assets and related obligation in liabilities.
• In case of operating lease, part of the Minimum lease payment (MLP) is
considered to be interest expense.
• In case of capital lease, the interest expense on the income statement includes
interest related to capital lease.
• Operating leases are not on the balance sheet, they are reflected on the income
statement in the rental expense.
• An operating lease is a type of long-term financing and the part of the lease
payment is really interest.
• One-third of the operating leases’ rental charges are included in the fixed
charges because this is an approximation of the proportion of lease payment
that is interest.
Leases
A lease is contractual agreement between a lessor (owner) and a lessee (user). It
gives a lessee the right to use an asset, owned by the lessor, for the term of the
lease. In return the lessee makes rental payments, called minimum lease payment
(MLP).
The two alternative methods for lease accounting reflect the differences in lease
contracts.
Capital Lease
A lease that transfers substantially all the benefits and risks of ownership is
accounted for as an asset acquisition and a liability incurrence by lessee. The
lessor treats such a lease as a sale and financing transaction. This type of lease is
called a capital lease.
If classified as a capital lease, both the leased asset and the lease obligation are
recognized on the balance sheet.
Operating Lease
In the case of operating leases, the lessee accounts for the minimum lease
payment as a rental expense, and no asset or liability is recognized on the balance
sheet.
A lessee (the party leasing the asset) classifies and accounts of a lease as a capital
lease if, at its inception, the lease meets any of four criteria:
1. The lease transfers ownership of the property to the lessee by the end of the
lease term.
2. The lease contains an option to purchase the property at a bargain price.
3. The lease term is 75% or more of the estimated economic life of the property.
4. The present value of he minimum lease payment (MLP) at the beginning of the
year is 90% or more of the fair value of the lease property.
A lease can be classified as an operating lease only when none of these criteria are
met.
Accounting for Leases-----An Illustration
We look only the effects on both the income statement and the balance sheet of
the lessee given the following information:
 • A company leases an asset on January 1, 2005 --- as it has no other assets or
liabilities.
• Estimated economic life of the leased asset is five years with an expected
salvage value of zero at the end of the five years. The company will
depreciate this asset on straight line basis over its economic life.
• The lease has a fixed noncancellable term of five years with annual minimum
lease payments of $2,505 paid at the end of each year.
• Interest rate on the lease is 8% per year.

Balance sheet consideration when determining Long-term Debt-Paying

Ability
The firm’s ability to carry debt, as indicated by the balance sheet, can be viewed
by considering the debt ratio and the debt/equity ratio. These ratios are now
reviewed.
Debt Ratio
The debt ratio indicates the firm’s long-term debt-paying ability. It is computed as
follows:
Total Liabilitie s
Debt Ratio =
Total Assets

Total Liabilities includes

1. Short-term liabilities,
2. Reserves,
3. Deferred tax liabilities,
4. Minority shareholders’ interests,
5. Redeemable preferred stock,
6. Any other noncurrent liabilities.
It does not include stockholders’ equity.
Short-term Liabilities
• Some firms exclude short-term liabilities because they are not long-term
sources of funds.
• Other firms include short-term liabilities because these liabilities become part of
the total sources of outside funds in the long run.
• Example is accounts payable are relatively short term but accounts payable in
total becomes a rather permanent part of the entire sources of funds.
• This book takes a conservative position that includes the short-term liabilities in
the debt ratio.
Reserves
• The reserve accounts classified under liabilities (some short-term and some
long-term).
• These are created by charging an expense to the income statement and an
equal increase in the reserve account on the balance sheet.
• These reserve accounts do not represent definite commitments to pay out
funds in the future but they are estimates of funds that will be paid out.
• This book takes a conservative position that includes the reserves in
liabilities in the debt ratio.
Deferred Taxes (Interperiod Tax Allocation)
• In the US, a firm may recognize certain income and expense items in one
period for the financial statements and in another period for the tax return.
• This can result in financial statement income in any one period that is
substantially different from tax return income.
• In the United States, taxes payable based on the tax return can be
substantially different from income expense based on financial statement
income.
 • The difference between tax expense and taxes payable is recorded as
deferred income taxes.
• The concept that results in deferred income taxes is called Interperiod tax
allocation.
• In addition to temporary differences, the tax liabilities can be influenced by
an operating loss carryback and /or operating loss carryforward.
• A company can elect to forgo a carryback.
• A corporate reports deferred taxes in two classifications:
• A net current account
• A net non-current amount
• The excess of tax depreciation over financial reporting
depreciation would be reported as a noncurrent liability.
• Some individuals disagree with the concept of deferred taxes
(Interperiod tax allocation). They consider the deferred tax to as soft account
due to uncertainty in payment and receipt. So, should be excluded from the
liabilities at the time of analysis.
• Examples of permanent differences are premiums on life
insurance and life insurance proceeds.
Minority Shareholders’ Interest
Some firms excludes and some includes but this book takes the conservative
position of including minority shareholders’ interest in the primary computation of
debt ratios
Redeemable Preferred Stock
It should be included in liabilities.
Debt/Equity Ratio

Total Liabilitie s
Debt/Equity Ratio =
Shareholde rs' Equity
Debt to Tangible Net worth Ratio
Total Liabilitie s
Debt to Tangible Net Worth =
Shareholde rs' Equity - Intangible Assets
Other Long-Term Debt-Paying Ability Ratios
Current Liabilitie s
Current Debt/net worth ratio = Shareholde rs' Equity
The higher the proportion of funds provided by current liabilities, greater the risk.
Total Capitalization Ratio
Long - Term Debt
Total Capitalization Ratio = Total Capitaliza tion
Total capitalization consists of long-term debt, preferred stock, common
stockholders’ equity.
The lower the ratio, the lower the risk.
Fixed Asset/Equity Ratio
This ratio indicates the extent to which shareholders have provided funds in
relation to fixed assets. Some firms subtract intangibles from the shareholders’
equity to obtain tangible net worth. This result is more conservative ratio. The
higher the fixed assets in relation to equity, the greater the risk.
Special Items that Influence a Firm’s Long-Term Debt-Paying Ability
1. Long-Term Assets versus Long-Term Debt
2. Long-Term Leasing
3. Pension Plans
i. Defined Contribution Plan
ii. Defined Benefit Plan
4. Postretirement Benefits other than Pensions
5. Joint Ventures
6. Contingencies
7. Financial Instruments with Off-Balance sheet Risk and Financial Instruments
with Concentrations of Credit Risk
8. Disclosures about Fair Value of Financial Instruments