Chapter 7

Long-Term
Debt-Paying Ability

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
 Times Interest Earned

Recurring Earnings, Excluding Interest

Expense, Tax Expense, Equity Earnings,
and Noncontrolling Interest
Interest Expense, Including Capitalized Interest

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #2
 Times Interest Earned (cont’d)

• Indicates long-term debt-paying ability

• Consider only recurring income
– Exclude discontinued operations
– Exclude extraordinary items
• Exclude (add back) to income
– Interest expense
– Income tax expense
– Equity losses (earnings) of nonconsolidated subsidiaries
– Noncontrolling loss (income)
• Include interest capitalized

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 7, Slide #3
 Times Interest Earned (cont’d)
• Comparisons
– 3 to 5 years of historical data
• Lowest value is the primary indicator of interest coverage
– Industry competitors and averages
• Secondary analysis
– Interest coverage on long-term debt
– Use only interest on long-term debt
• Not practical for external analysis
• Short-run coverage
– Add back noncash expenses to recurring income
– Less conservative

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #4
 Fixed Charge Coverage

Recurring Earnings, Excluding Interest

Expense, Tax Expense, Equity Earnings,
and Noncontrolling Interest
+ Interest Portion of Rentals
Interest Expense, Including Capitalized Interest
+ Interest Portion of Rentals

• Ratio trend is usually similar to trend of times-

interest-earned ratio

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #5
 Fixed Charge Coverage (cont’d)

• Fixed charges include

– Interest portion of operating lease payments
• General approximation: 1/3 of payments
• SEC requires specific calculation using lease terms
– May also include
• Depreciation, depletion, and amortization
• Debt principal payments
• Pension payments
• Substantial preferred stock dividends
• The more items included as “fixed charges,” the
more conservative the ratio

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #6
 Debt Ratio

Total Liabilities
Total Assets
• Indicates the percentage of assets financed by creditors
• Comparisons
– Industry competitors and averages
• Variations in application
– Short-term liabilities
• Not part of long-term source of funds: exclude
• Part of the total source of funds: include
– Liabilities that do not necessarily represent a commitment to
pay out funds in the future

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #7
 Debt Ratio and Certain Liabilities

• Reserves
– Matches an expense but is not a liability per se
– Infrequently used in U.S. GAAP statements
– Include in ratio for conservative application
• Deferred Income Taxes
– Difference between income tax expense and income
taxes payable
– Commonplace in U.S. GAAP statements
– Recognized as a liability by GAAP; include in ratio

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #8
 Debt Ratio and Certain Liabilities (cont’d)

• Noncontrolling Interest
– Proportion of a consolidated entity that is not owned
by the controlling parent company
– Appears on the balance sheet as part of
stockholders’ equity
– Include in ratio for conservative application
• Redeemable Preferred Stock
– Exclude from ratio; does not present a normal debt
relationship
– Include in ratio for conservative application

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #9
 Debt/Equity Ratio

Total Liabilities
Shareholders' Equity

• Helps determine how well creditors are

protected in case of insolvency
• Comparisons
– Industry competitors and averages

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #10
 Debt to Tangible Net Worth Ratio

Total Liabilities
Shareholders' Equity - Intangible Assets

• Determines the entity’s long-term debt payment ability

• Indicates how well creditors are protected in case of
the firm’s insolvency
• More conservative than debt ratio or debt/equity ratio
due to exclusion of intangibles

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #11
Other Long-Term Debt-Paying Ability Ratios

• Current debt/net worth ratio

– The relationship between current liabilities and funds
contributed by shareholders
• Total capitalization ratio
– Compares long-term debt to total capitalization
– Total capitalization: long-term debt, preferred stock,
and common stockholders’ equity
• Fixed asset/equity ratio
– The extent to which shareholders have provided
funds in relation to fixed assets

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #12
Long-Term Assets vs. Long-Term Debt

• Consider the assets of the firm when

determining the long-term debt-paying ability
• Ability for analysis is limited
– Financial statements do not disclose market or
liquidation value
– Certain assets may have market value significantly
greater then carrying value
• Certain assets may have earnings potential in
the future

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #13
 Long-Term Leasing

• Capital leases
– Asset and liability are reported on the balance sheet
• Operating leases
– Reported as expense on the income statement
– Supplemental analysis using future payments
• One-third can be estimated as interest
• Two-thirds can be added to the fixed assets and long-term
liabilities for debt ratio analyses

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #14
 Pension Plans

• Employee Retirement Income Security Act

(ERISA)
– Includes provisions requiring
• Minimum funding of plans
• Minimum rights to employees upon termination of their
employment
• Creation of the Pension Benefit Guaranty Corporation

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #15
 Defined Contribution Plan

• Contributions to the plan are specified

• Employer bears no risk for future growth of
plan
• No complex expense or liability issues
• 401K is a type of defined contribution plan
• Trend analysis
– Compare three years of pension expense in
relationship to operating revenue and income
before income taxes

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #16
 Defined Benefit Plan

• Defines the benefits to be received

• Employer must fund sufficiently to achieve
benefit
• Note actuarial assumptions inherent in the plan
– Interest (discount) rates
– Employee turnover
– Mortality rates
– Compensation
– Pension benefits

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #17
 Defined Benefit Plan (cont’d)

• Compare three years of

– Pension expense in relationship to operating
revenue and income before income taxes
• Compare benefit obligations to plan assets
– Underfunded: a potential liability
– Overfunded: potential opportunities to reduce future
pension expense and/or reduce related costs

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #18
 Postretirement Benefits
Other than Pensions

• Prior to 1993, accrual was not required

• Transition costs may be
– Amortized over 20 years or
– Expensed in the year of adopting the new
recognition practice
• Analysis is similar to defined benefit pension
– Exception: no rate of compensation increase

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #19
 Joint Ventures
• An association of two or more businesses established
for a special purpose
• Consolidation
– Parent firm has control
• Carry as an investment
– Parent firm has significant influence
• Analysis
– Review footnote for commitments relating to the joint venture
– Off-balance sheet commitments represent potential liabilities

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #20
 Contingencies

• Loss contingencies that are not accrued are

footnoted if it is reasonably possible that an
asset has been impaired or a liability has been
incurred
– Review contingency note for possible liabilities not
disclosed on the balance sheet
• Gain contingencies are not accrued

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #21
 Financial Instruments with
Off-Balance-Sheet Risk

• Disclosure is required of
– Contract face amount
– Nature and terms of the instrument
– Amount of the potential loss
– Entity’s collateral policy and description of the
collateral
• Risk: Potential loss if
– The co-party fails to perform
– Changes in market make instrument less valuable

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #22
 Financial Instruments
with Concentrations of Credit Risk

• Disclosure is required of
– The extent of risk from exposures to individuals or
groups of counterparties in the same industry or
region

• Small companies are particularly susceptible

to concentration risk

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #23
 Disclosures About
Fair Value of Financial Instruments

• Disclosure of financial instrument fair value is

required
– On-balance sheet assets and liabilities
– Off-balance sheet assets and liabilities

• If estimation of fair value is not practicable

– Descriptive information pertinent to estimating fair
value is provided

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 7, Slide #24