Financial Accounting Fifth Edition

Long-Term
Liabilities

CHAPTER

9 Spiceland • Thomas • Herrmann

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Part A
TYPES OF LONG-TERM DEBT

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Learning Objective 1

LO9–1 Explain financing alternatives.

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Financing Alternatives
• Capital structure: mixture of liabilities and
stockholders’ equity a business uses
 Debt financing: borrowing money
 Equity financing: obtaining investment from
stockholders
• Cost of financing
 Debt: interest expense (tax-deductible)
 Equity: dividends (not tax-deductible)
• Examples of debt
 Notes, leases, and bonds

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Key Point
Companies obtain external funds through debt
financing (liabilities) and equity financing
(stockholders’ equity). One advantage of debt
financing is that interest on borrowed funds is
tax-deductible.

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Concept Check 9–1
Which of the following statements is true?
a. Profits generated by a company are a source of
external financing.
b. Dividends paid are a tax-deductible expense.
c. Interest paid on debt is a tax-deductible
expense.
d. All of the above are true.
Interest paid on debt is a tax-deductible expense,
whereas dividends paid are not tax-deductible and are
not an expense. Profits generated by a company are
referred to as internal financing (not external financing).
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Learning Objective 2

LO9–2 Account for installment notes payable.

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Installment Notes
• Most car loans and home loans call for
payment in monthly installments rather than
by a single amount at maturity
• Each installment payment includes both:
1. Interest on borrowed amount
2. Reduction of outstanding loan balance
• Companies, too, often borrow cash using
installment notes.

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Illustration 9–1
Amortization Schedule for an
Installment Note
Assume a $25,000, 6%, four-year loan for a new delivery truck
on November 1, 2021. Payments of $587.13 are required at
the end of each month for 48 months.
(1) (2) (3) (4) (5)
Interest Decrease in
Date Cash Paid Expense Carrying Value Carrying Value
Carrying Value × Prior Carrying
Interest Rate (2) – (3) Value – (4)
11/1/2021 Carrying value × 6% × 1/12 $25,000.00
11/30/2021 $ 587.13 $125.00 $462.13 24,537.87
12/31/2021 587.13 122.69 464.44 24,073.43
* * * * *
12/31/2022 587.13 94.04 493.09 18,315.65
* * * * *
9/30/2025 587.13 5.83 581.30 584.21
10/31/2025 587.13 2.92 584.21 0
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Installment Loan Transactions
Establishment of the Note Payable
November 1, 2021 Debit Credit
Cash …………………...……..….….….……………………………….. 25,000
Notes Payable ………………………………………………….. 25,000
(Issue a note payable)
First two monthly payments
November 30, 2021 Debit Credit
Interest Expense (= $25,000 × 6% × 1/12) ……………… 125.00
Notes Payable (difference) ……………………………..……… 462.13
Cash (monthly payment) ………………………….………… 587.13
(Pay monthly installment on note)
$25,000 − $462.13
December 31, 2021
Interest Expense (= $24,537.87 × 6% × 1/12) …………… 122.69
Notes Payable (difference) ……………………………..……….. 464.44
Cash (monthly payment) ………………………….………….. 587.13
(Pay monthly installment on note)
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Key Point
Most notes payable require periodic installment
payments. Each installment payment includes an
amount that represents interest expense and an
amount that represents a reduction of the
carrying value (remaining loan balance).

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Concept Check 9–2
Tropical Paradise borrows $24,000 and agrees to a
5%, five-year installment loan with the bank.
Payments of $452.91 are due at the end of each
month. How much interest should be recorded for
the first month?
a. All $452.91 is attributable to interest.
b. $100.00 The payment of $452.91 includes payment for both
c. $352.91 interest expense and a portion of the principal. The
interest expense for the first month is the carrying
d. $0 value multiplied by (the interest rate × 1/12):
$24,000 × 5% × 1/12 = $100.00
The remaining portion of the payment ($352.91)
reduces the carry value.
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Learning Objective 3

LO9–3 Understand how leases are recorded.

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Leases
• Contractual arrangement by which the lessor
(owner) provides the lessee (user) the right to
use an asset for a specified period of time
• Leases are recorded by the lessee as a debit to
lease asset and a credit to lease payable
 for the present value of the lease payments
 at the beginning of the lease term

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Decision Maker’s Perspective
Why Do Many Companies Lease Rather Than Buy?
1. Leasing reduces the upfront cash needed
to use an asset.
2. Lease payments often are lower than
installment payments.
3. Leasing offers flexibility and lower costs
when disposing of an asset.
4. Leasing may offer protection against the
risk of declining asset values.
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Calculating the Present Value of
Lease Payments (Annuity)
• Table 4 at the back of the book provides present
values of annuities of $1 (ordinary annuity).
• These values are multiplied by the monthly lease
payment to get the present value of the total lease
payments.
• To use the table, you need to know n (time periods)
and i (interest rate.)
• For combinations of n and i not shown, you can
calculate the present value of the lease payments
using a financial calculator or Excel.
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Illustration 9–2
Present Value of Lease Payments Using a
Financial Calculator
• A company agrees to make lease payments of
$352.28 at the end of each month for 48 months,
assuming a 6% borrowing rate.
CALCULATOR INPUT
Lease characteristics Key Amount
1. Future value FV $0
2. Lease payment PMT $352.28
3. Number of payments N 48 = 4 years × 12 periods each year
4. Interest rate I 0.5 = 6% ÷ 12 periods each year
CALCULATOR OUTPUT
Present value of payments PV $15,000

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Illustration 9–3
Present value of Lease Payments Using Excel

Formula

$0
$352.28
48
Inputs
0.005

$15,000 PV

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Recording Lease Payable
• At the beginning of the lease, record:
 Lease asset – right to use the asset over lease period
 Lease payable – present value of obligation to make payments

November 1, 2021 Debit Credit

Lease Asset ….…………………………………………….. 15,000
Lease Payable ……………………………………… 15,000
(Record the lease)
($15,000 = present value of lease payments*)

*present value of ordinary annuity; n = 48, i = 6% ÷ 12.

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Key Point
While not transferring ownership as in a
purchase, a lease gives the lessee (user) the
right to use the asset over the lease period. This
right is recorded as an asset, and the obligation
to make lease payments is recorded as a liability.

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Concept Check 9–3
Which of the following is an advantage of leasing an asset over
purchasing an asset on the installment basis?
a. Leasing reduces the upfront cash needed to use an
asset.
b. Lease payments are usually higher than installment
payments.
c. Leased assets do not result in liabilities on the
balance sheet.
d. The leased asset carrying value includes interest in
the asset account rather than an expense account.
Instead of paying cash upfront for the full purchase of an asset, only the first month’s lease payment is
needed to begin using the asset. Answer a. is correct.
Lease payments are usually lower than installment payments. Leased assets do result in liabilities;
the initial recording includes a debit to lease asset and credit to lease payable for the present value of
the payments. Interest is not included in the asset amount; the asset is recorded at present value and
interest is calculated each period and charged to expense.
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Education.
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Learning Objective 4

LO9–4 Identify the characteristics of bonds.

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What Are Bonds?
• Formal debt instrument that obligates the
borrower to repay a stated amount, referred to as
the principal or face amount, at a specified
maturity date
• The borrower also agrees to pay interest over the
life of the bond
• Traditionally, interest on bonds is paid twice a
year (semiannually) on designated interest dates,
beginning six months after the original bond issue
date

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Illustration 9–4
Summary of Bond Characteristics

Bond
Characteristic Definition
Secured Bonds are backed by collateral.
Unsecured Bonds are not backed by collateral.
Term Bond issue matures on a single date.
Serial Bond issue matures in installments.
Callable Issuing company can pay off bonds early.
Convertible Investor can convert bonds to common stock.

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Illustration 9–5
Timeline of a Bond Issue
On January 1, 2021, California Coasters raises money for development of its
new roller coaster by issuing $100,000 of bonds paying a stated interest rate
of 7% each year. The bonds are due in 10 years, with interest payable
semiannually on June 30 and December 31 each year.

Face Amount = $100,000

Amount investors (Due at maturity)
willing to pay for bond +
Interest Payments = $3,500 each
(= $100,000 × 7% × ½ year)
Issue
Price
? $3,500 $3,500 $3,500 $3,500 $3,500 $3,500 $3,500 $3,500

Jan. 1, Dec. 31, Dec. 31, Dec. 31, Dec. 31,

2021 2021 2022 2029 2030
Issue Maturity
Date Date

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Key Point
The distinguishing characteristics of bonds
include whether they are backed by collateral
(secured or unsecured), become due at a
single specified date or over a series of years
(term or serial), can be redeemed prior to
maturity (callable), or can be converted into
common stock (convertible).

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Concept Check 9–4
Which of the following bonds always matures on a
single date?
a. A serial bond
b. A term bond
c. A secured bond
d. A convertible bond

A term bond is a bond issue that matures on a single date.

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Part B
ACCOUNTING FOR BONDS PAYABLE

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Learning Objective 5

LO9–5 Record the issuance of bonds and related

interest.

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Bonds Issued at Face Amount
(1 of 2)
• California Coasters issues $100,000 of bonds
paying 7% interest for $100,000 (face amount).
January 1, 2021 Debit Credit
Cash …………………...……..….….….………………… 100,000
Bonds Payable ……………………………………… 100,000
(Issue bonds at face amount)

• First semiannual interest payment:

June 30, 2021 Debit Credit
Interest Expense …………………...……..….….…. 3,500
Cash …………………………………………………….. 3,500
(Pay semiannual interest)
($3,500 = $100,000 × 7% × 1/2)

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Stated Interest Rate versus Market
Interest Rate
• The stated interest rate is specified in the
bond contract.
• The market interest rate is not specified in
the bond contract.
• Investors demand a higher market rate for
bonds that have a higher default risk.
• Bonds may be issued at the face amount, or
at a discount or premium.

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Bonds Issued at a Discount

• Issue $100,000 of bonds paying 7% interest for $93,205

(discount), assuming an 8% market interest rate
January 1, 2021 Debit Credit
Cash …………………...……..….….….…………………. 93,205
Discount on Bonds Payable ........................ 6,795
Bonds Payable …………………………………….. 100,000
(Issue bonds at a discount)

Long-term liabilities:
Bonds payable $100,000
Less: Discount on bonds payable (6,795)
Carrying value $ 93,205

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Common Mistake
Students sometimes incorrectly record
interest expense using the stated rate rather
than the market rate. Remember that interest
expense is the carrying value times the
market rate, while the cash paid for interest is
the face amount times the stated rate.

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Illustration 9–6
Amortization Schedule for Bonds Issued at a
Discount
(1) (2) (3) (4) (5)
Increase in
Carrying
Date Cash Paid Interest Expense Carrying
Value
Value

Face
Prior
Amount × Carrying Value ×
(3) – (2) Carrying
Stated Market Rate
Value + (4)
Rate
1/1/2021 $93,205
6/30/2021 $3,500 $3,728 $228 93,433
12/31/2021 3,500 3,737 237 93,670
* * * * *
* * * * 99,057
6/30/2030 3,500 3,962 462 99,519
12/31/2030 3,500 3,981 481 100,000
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Interest Expense and Interest
Payment—Bonds Issued at a Discount
• First semiannual interest payment:
June 30, 2021 Debit Credit
Interest Expense (= $93,205 × 8% × 1/2)………. 3,728
Discount on Bonds Payable (difference)….. 228
Cash (= $100,000 × 7% × 1/2) ……………………. 3,500
(Pay semiannual interest)

• Second semiannual interest payment:

December 31, 2021 Debit Credit
Interest Expense (= [$93,205 + $228] × 8% × 1/2). 3,737
Discount on Bonds Payable (difference)……….. 237
Cash (= $100,000 × 7% × 1/2) ………………………... 3,500
(Pay semiannual interest)

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Bonds Issued at a Premium

• Issue $100,000 of bonds, paying 7% interest for $107,439

(premium), assuming a 6% market interest rate
January 1, 2021 Debit Credit
Cash …………………...……..….….….………………….. 107,439
Bonds Payable ………………………………………. 100,000
Premium on Bonds Payable (difference)… 7,439
(Issue bonds at a premium)

Long-term liabilities:
Bonds payable $100,000
Add: Premium on bonds payable 7,439
Carrying value $107,439

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Illustration 9–7
Amortization Schedule for Bonds Issued
at a Premium
(1) (2) (3) (4) (5)
Decrease
Cash Interest Carrying
Date in Carrying
Paid Expense Value
Value

Face Prior
Amount Carrying Value × Carrying
(2) – (3)
× Stated Market Rate Value –
Rate (4)
1/1/2021 $107,439
6/30/2021 $3,500 $3,223 $277 107,162
12/31/2021 3,500 3,215 285 106,877
* * * * *
* * * * 100,956
6/30/2030 3,500 3,029 471 100,485
12/31/2030 3,500 3,015 485 100,000

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Illustration 9–8
Changes in Carrying Value over Time

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Key Point
When bonds issue at face amount, the
carrying value and the corresponding
interest expense remain constant over time.
When bonds issue at a discount (below face
amount), the carrying value and the
corresponding interest expense increase
over time. When bonds issue at a premium
(above face amount), the carrying value and
the corresponding interest expense
decrease over time.
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Concept Check 9–5
If a 10-year bond is issued with a stated rate of 9%
when the market rate is 8%, the bonds will be issued
at ______?
a. A premium
b. A discount
c. Face amount
d. Cannot determine with information given

The bonds will be issued at a premium because the stated

rate is higher than the market rate of the bond.

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Learning Objective 6

LO9–6 Record the retirement of bonds.

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Retirement of Bonds
• Company buys back its bonds from investors.
• If bonds are retired at maturity, the carrying
value will equal the face amount. The bond
payable is debited and cash is credited.
• Bonds can be retired before maturity by
 Exercising the call feature included in the bond
contract or buying the bonds in the open market
 Retirement before maturity is called early
extinguishment of debt, and may result in a gain or
loss equal to the difference between the book value of
the bond and the price paid to retire the bond.
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Bond Retirements at Maturity
• Bond retirements occur when the issuing
corporation buys back its bonds from the
investors
• Assume $100,000 in bonds are retired at
maturity (December 31, 2030)
December 31, 2030 Debit Credit
Bonds Payable …………………...……..….….….…. 100,000
Cash ……………………………………………………… 100,000
(Retire bonds at maturity)

No gain or loss is recorded on bonds retired at maturity.

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Bond Retirements before Maturity
California Coasters issued bonds on January 1, 2021, above
face amount (at a premium) at $107,439. The carrying value of
the bonds one year later on December 31, 2021, is $106,877.
Record the bond retirement before maturity on December 31,
2021, for $114,353.

December 31, 2021 Debit Credit

Bonds Payable (account balance) ..….….….…… 100,000
Premium on Bonds Payable ….….….……………… 6,877
Loss (difference) ….….….……………………………….. 7,476
Cash (amount paid) …………………………………. 114,353
(Retire bonds before maturity)
California Coasters records a loss for the difference between
the price paid to repurchase the bonds ($114,353) and the
bonds’ carrying value ($106,877).
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Why Buy Back Debt Early?
• When interest rates decrease, companies with a call
feature are more likely to repurchase higher-cost debt and
then reissue debt at new, lower interest rates. This type of
buyback and reissue lowers future interest expense.
• Another reason to repay debt early is to improve the
company’s debt ratios (discussed later in the chapter).
• Early extinguishment of debt can also be timed to manage
reported earnings. Since bonds payable are reported at
carrying values and not market values, firms can time their
repurchase of bonds to help meet earnings expectations.
For instance, when interest rates go up, bond prices go
down. In this case, a company will record a gain rather than
a loss on early extinguishment.

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Key Point

No gain or loss is recorded on bonds retired at

maturity. For bonds retired before maturity,
we record a gain or loss on early
extinguishment equal to the difference
between the price paid to repurchase the
bonds and the bonds’ carrying value.

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Part C
PRICING A BOND

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Learning Objective 7

LO9–7 Calculate the issue price of a bond.

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Calculating the Issue Price of a
Bond
• The issue price of a bond equals the present
value of the bond’s face amount plus the present
value of its periodic interest payments. To
calculate these present values, we need to know
 The face amount of the bond.
 The interest payment each period based on the stated
interest rate of the bond.
 The number of periods until the bond matures.
 The market interest rate per period.
• Except for the market interest rate, these items
are found in the bond contract.

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Example of Calculating Issue Price
• In our earlier example for California
Coasters, the face amount equals $100,000.
• The interest payment every six months is
$3,500 (= $100,000 × 7% × 1/2 year) based on
the bond’s stated interest rate of 7%.
• The number of periods to maturity is 20
because the bonds pay interest semiannually
(twice per year) for 10 years.

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Bonds Issued at Face Amount
(2 of 2)
• There are three ways to determine the issue
price of a bond. We will apply those three
methods to bonds issued at their face
amount. The three methods are listed here,
and are demonstrated on the next three
slides.
 Use a financial calculator (Illustration 9–9)
 Use Excel (Illustration 9–10)
 Use present value table factors (Illustration 9–11)

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Illustration 9–9
Pricing Bonds Issued at Face Amount Using
a Financial Calculator

CALCULATOR INPUT
Bond characteristics Key Amount
1. Face amount FV $100,000
2. Interest payment PMT $3,500 = 100,000 × 7% × 1/2 year
3. Number of periods N 20 = 10 years × 2 periods each year
4. Market interest rate I 3.5 = 7% ÷ 2 periods each year

CALCULATOR OUTPUT
Issue price PV $100,000

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Illustration 9–10
Pricing Bonds Issued at Face Amount Using
Excel

$100,000
$3,500
20
0.035

$100,000

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Illustration 9–11
Pricing Bonds Issued at Face Amount Using
Present Value Tables
= $100,000 ×
Present value of face amount = $ 50,257
0.50257*

Present value of interest = $3,500+ ×

= 49,743
payments 14.21240**

Issue price of the bonds $100,000

+$100,000 × 7% × 1/2 year = $3,500

*Table 2, i = 3.5%, n = 20
**Table 4, i = 3.5%, n = 20

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Bonds Issued at a Discount or
Premium
• The following three slides demonstrate the
calculation of the issue price when there is a
discount. Then, the next three demonstrate
the calculation of the issue price when there is
a premium.

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Illustration 9–12
Pricing Bonds Issued at A Discount Using a
Financial Calculator

CALCULATOR INPUT
Bond characteristics Key Amount
1. Face amount FV $100,000
2. Interest payment PMT $3,500 = 100,000 × 7% × 1/2 year
3. Number of periods N 20 = 10 years × 2 periods each year
4. Market interest rate I 4 = 8% ÷ 2 periods each year

CALCULATOR OUTPUT
Issue price PV $93,205

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Illustration 9–13
Pricing Bonds Issued at a Discount Using
Excel

$100,000
$3,500
20
0.04

$93,205

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Illustration 9–14
Pricing Bonds Issued at a Discount Using
Present Value Tables

Present value of principal = $100,000 × 0.45639* = $ 45,639

Present value of interest

= $3,5001 × 13.59033** = 47,566
payments

Issue price of the bonds $93,205

1$100,000 × 7% × 1/2 year = $3,500

*Table 2, i = 4%, n = 20
**Table 4, i = 4%, n = 20

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Common Mistake
The interest rate we use to calculate the bond
issue price is always the market rate, never the
stated rate. Some students get confused and
incorrectly use the stated rate to calculate
present value. Use the stated rate to calculate
the interest payment each period, but use the
market rate to calculate the present value of the
cash flows.

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Illustration 9–15
Pricing Bonds Issued at A Premium Using a
Financial Calculator

CALCULATOR INPUT
Bond characteristics Key Amount
1. Face amount FV $100,000
2. Interest payment PMT $3,500 = 100,000 × 7% × 1/2 year
3. Number of periods N 20 = 10 years × 2 periods each year
4. Market interest rate I 3 = 6% ÷ 2 periods each year

CALCULATOR OUTPUT
Issue price PV $107,439

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Illustration 9–16
Pricing Bonds Issued at a Premium Using
Excel

$100,000
$3,500
20
0.03

$107,439

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 Illustration 9–17
Pricing Bonds Issued at a Premium Using
Present Value Tables

Present value of principal = $100,000 × 0.55368* = $ 55,368

Present value of interest = $3,5001 ×

= 52,071
payments 14.87747**

Issue price of the

$107,439
bonds

1$100,000 × 7% × 1/2 year = $3,500

*Table 2, i = 3%, n = 20
**Table 4, i = 3%, n = 20

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Illustration 9–18
Stated Rate, Market Rate, and the Bond
Issue Price

Bonds Issued at a Bonds Issued at Bonds Issued at a

Discount Face Amount Premium

Stated rate (7%) Stated rate (7%) Stated rate (7%)

less than equal to greater than
Market rate (8%) Market rate (7%) Market rate (6%)

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Key Point

The issue price of a bond is equal to the present

value of the face amount (principal) payable at
maturity, plus the present value of the periodic
interest payments. Bonds can be issued at face
amount, below face amount (at a discount), or
above face amount (at a premium).

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Concept Check 9–6
Which of the following statements is true for bonds
issued at a discount?
a. The stated interest rate > market rate
b. The stated interest rate < market rate
c. The stated interest rate = market rate
d. The stated interest rate is unrelated to the
market rate

Bonds will be sold at less than the face value, or at a

discount, when the stated interest rate is less than the
market interest rate.

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Concept Check 9–7
A company retires a $50 million bond issue before
maturity when the carrying value is $48 million, but
the market value is $54 million. The company will
record:
a. A loss of $6 million
b. A gain of $6 million
c. Neither a gain nor a loss
d. A debit to Cash of $54 million
To compute the gain or loss, compare the bond’s carrying
value to the market value. In this case the carrying value is
$48 million, but the company will retire the bonds at the
market value of $54 million, resulting in a loss of $6 million.
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Analysis
DEBT ANALYSIS
Coca-Cola vs. PepsiCo

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Learning Objective 8

LO9–8 Assess the impact of long-term debt on risk

and return.

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Debt Analysis
• Long-term debt is one of the first places
decision makers look when trying to get a
handle on risk
• Two ratios used to measure financial risk
related to long-term liabilities:
 Debt to equity ratio
 Times interest earned ratio

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Illustration 9–19
Toys R Us Notes to the Financial
Statements (excerpt)
Toys R Us
Notes to the Financial Statements (excerpt).
Our substantial indebtedness could have significant consequences, including, among
others,
• increasing our vulnerability to general economic and industry conditions;
• reducing our ability to fund our operations and capital expenditures, capitalize on
future business opportunities, expand our business and execute our strategy;
• increasing the difficulty for us to make scheduled payments on our outstanding debt;
• exposing us to the risk of increased interest expense;
• causing us to make non-strategic divestitures;
• limiting our ability to obtain additional financing;
• limiting our ability to adjust to changing market conditions and reacting to competitive
pressure, placing us at a competitive disadvantage compared to our competitors who
are less leveraged.

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Debt to Equity Ratio
• A measure of risk.
• Other things being equal, the higher the debt
to equity ratio, the higher the risk of
bankruptcy. When a company assumes more
debt, risk increases.

Debt to equity ratio = Total liabilities

Stockholders’ equity

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Illustration 9–20 (1 of 2)
Financial Information for Coca-Cola and PepsiCo
Selected Balance Sheet Data
December 31, 2016 and 2015 ($ in millions)
Coca-Cola PepsiCo
2016 2015 2016 2015
Total assets $87,270 $89,996 $74,129 $69,667
Total liabilities $64,050 $64,232 $62,930 $57,637
Stockholders’ equity 23,220 25,764 11,199 12,030
Total liabilities and equity $87,270 $89,996 $74,129 $69,667

Illustration 9–21
Debt to Equity Ratio for Coca-Cola and PepsiCo
Total Stockholders’ Debt to
($ in millions) Liabilities ÷ Equity = Equity Ratio
Coca-Cola $64,050 ÷ $23,220 = 2.76
PepsiCo $62,930 ÷ $11,199 = 5.62

Pepsi has higher leverage than Coke.

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Illustration 9–22
Return on Assets for Coca-Cola and PepsiCo

Average
($ in Net Return
÷ Total =
millions) Income on Assets
Assets
Coca-
$6,550 ÷ $88,633* = 7.4%
Cola
$71,898**
PepsiCo $6,379 ÷ = 8.9%

*($87,270 + $89,996)/2
**($74,129 + $69,667)/2

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Times Interest Earned Ratio
• An indication to creditors of how many
“times” greater earnings are than interest
expense

Times interest Net income + Interest expense + Tax expense

earned ratio = Interest expense

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Illustration 9–20 (2 of 2)
Financial Information for Coca-Cola and PepsiCo
Income Statements
For the year ended December 31, 2016 ($ in millions)
Coca-Cola PepsiCo
Net Sales $41,863 $62,799
Cost of goods sold 16,465 28,209
Gross profit 25,398 34,590
Operating expenses 16,772 24,805
Other income 243 110
Interest expense 733 1,342
Tax expense 1,586 2,174
Net income $ 6,550 $ 6,379

Illustration 9–23
Times Interest Earned Ratio for Coca-Cola and PepsiCo
Net Income + Times
Interest Expense + Interest Interest
($ in millions) Tax Expense ÷ Expense = Earned Ratio

Coca-Cola $8,869 ÷ $ 733 = 12.1

PepsiCo $9,895 ÷ $1,342 = 7.4
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Key Point
The debt to equity ratio is a measure of financial
leverage. Taking on more debt (higher leverage)
can be good or bad depending on whether the
company earns a return in excess of the cost of
borrowed funds. The times interest earned ratio
measures a company’s ability to meet interest
payments as they become due.

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Concept Check 9–8
Which of the following ratios best measures
financial leverage?
a. Return on assets
b. Inventory turnover
c. Times interest earned
d. Debt to equity ratio

The debt to equity ratio is a measure of financial leverage.

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End of Chapter 9

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