Financial Statements Analysis Fall term 2023-2024

Tutorial 6

Long-Term Debt-Paying Ability

Problems

1 Consider the following information about THE GEO GROUP:

THE GEO GROUP INC.

Consolidated income statement for the year ended December 31, N

Revenues 1 141 090

Operating expenses 897 099
Depreciation and amortization 39 306
General and administrative expenses 69 240
Operating income 135 445
Interest income 4 943
Interest expense 28 518
Loss on extinguishment of debt 6 839
Income before taxes, equity in earnings of affiliates and discontinued operations 105 031
Provision for income taxes 42 079
Equity in earnings of affiliates (net of income tax provision of $1 368) 3 517
Income from continuing operations 66 469
Loss from discontinued operations (net of income tax benefit of $216) (346)
Net income before noncontrolling interest 66 123
Earnings attributable to noncontrolling interest (169)
Net income 65 954
Property and Equipment:

Useful life (years) December 31, N

Land - 97 393
Buildings and improvements 2 to 50 1 131 895
Leasehold improvements 1 to 29 260 167
Equipment 3 to 10 77 906
Furniture and fixtures 3 to 7 18 453
Facility construction in progress 120 584
1 706 398
Less accumulated depreciation and amortization (195 106)
Property and equipment, net 1 511 292

Note about Construction in progress: the company construction in progress primarily consists of
development costs associated with the Facility Construction and Design segment for contracts with
various federal, state and local agencies for which we have management contracts. Interest
capitalized in property and equipment is $4 900 for the year ended December 31, N.

Required:

a. What is the interest reported on the income statement?

b. What is the interest added to property and equipment in the year N? What was the effect on
income from capitalizing interest?
c. When is capitalized interest recognized as an expense? Explain.

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d. Compute the times interest earned for the year N.

e. Assume that the general expenses include a rental of $6 000 relating to a lease contract for
which the asset wasn’t capitalized. Compute the fixed charge coverage ratio. What is the
purpose of computing this ratio?

Answer:

a. The income expense reported on the income statement is $28 518.

b. According to the notes, the capitalized interest added to the cost of the construction in
progress is $4 900. Since the interest was added to the cost of the asset, it wasn’t expensed.
So, it doesn’t appear on the income statement.
c. The capitalized interest will be expensed when the asset reported as construction in progress
is completed. In other terms, the capitalized interest will become part of the depreciation
expense when the fixed asset is depreciated.
105 031+ 28518
d. Times interest earned= = 4 times per year
28 518+ 4 900
105 031+ 28518+ 6 000/3
e. Fixed charge coverage ratio = = 3.83 times per year
28 518+ 4 900+6 000 /3
The intent of this ratio is to compute the coverage of the true interest expense through the
recurring earnings. The interest portion of rentals approximates the annual interest expense
on leasing contracts which weren’t capitalized. The related lease was accounted for as an
operating lease but it constitutes in substance a financing arrangement. So, part of the rental
is in substance interest.

2 Allen Company and Barker Company are competitors in the same industry. Selected financial data
from their statements, for the period N, follow.

Balance Sheet December 31, N

Allen Company Barker Company

Cash $10 000 $35 000
Accounts receivable 45 000 120 000
Inventory 70 000 190 000
Investments 40 000 100 000
Intangibles 11 000 20 000
Property, plant and equipment 180 000 520 000
Total assets 356 000 985 000
Accounts payable 60 000 165 000
Bonds payable 100 000 410 000
Preferred stock, $1 par 50 000 30 000
Common stock, $10 par 100 000 280 000
Retained earnings 46 000 100 000
Total liabilities and capital 356 000 985 000

Income statement

For the year ended December 31, N

Allen Company Barker Company

Sales $1 050 000 $2 800 000
Cost of goods sold 725 000 2 050 000
Selling and administrative expenses 230 000 580 000

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Interest expense 10 000 32 000

Income taxes 42 000 65 000
Net income 43 000 73 000
Industry averages:
Times interest earned 7.2 times
Debt ratio 40.3%
Debt/equity 66.6%
Debt to tangible net worth 72.7%
Required:

a. Compute the following ratios for each company:

1. Times interest earned
2. Debt ratio
3. Debt/equity ratio
4. Debt to tangible net worth
b. Is Barker Company in a position to take on additional long-term debt? Explain.
c. Which company has the better long-term debt position? Explain.

Answer: Same solutions as Tutorial 6 fall 2021.

a.

Allen company Barker company

Times interest earned 9.5 5.3
Debt ratio 44.9% 58.4%
Debt/equity 81.6% 140.2%
Debt to tangible net worth 86.5% 147.4%
b.
Compare Barker company ratios to industry averages.
Coverage of interest is less than industry. Debt ratio, debt/equity and debt to tangible net
worth ratios are higher than industry
c.
Allen company: better times interest earned, better debt ratio, debt/equity and debt to
tangible net worth

3 Mr. Parks has asked you to advise him on the long-term debt-paying ability of Arodex Company. He
provides you with the following ratios:

N N-1 N-2
Times interest earned 8.2 6.0 5.5
Debt ratio 40% 39% 40%
Debt to tangible net worth 80% 81% 81%
Required:

a. Give the implications and the limitations of each item separately and then the collective
influence that could be drawn from them about Arodex Company’s long-term debt position.
b. What warnings should you offer Mr. Parks about the limitations of ratio analysis for the
purpose stated here?

Answer: Same solutions as Tutorial 6 fall 2021.

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a. Times interest earned:

- The ratio relates recurring earnings before interest, tax, noncontrolling interest and equity
earnings to interest expense.
- The ratio measures the ability of the firm to cover its interest expense from its recurring
earnings. High and stable ratios are preferred.
- There is material improvement in times interest earned: improvement in long-term debt-
paying position. We also notice that the debt ratio and the debt to tangible net worth
remained relatively constant. So the times interest earned improvement suggests an increase
in profits.
- The ratio only indicates interest coverage (income statement approach only).
- The ratio does not consider other possible fixed charges.

Debt ratio:

- The ratio measures the proportion of assets financed by debt/creditors. Lower ratios are
preferred.
- Steady ratio over 3 years: about 40%. There is no industry average provided, however, for
most firms a debt ratio of 40% is reasonable.
- Debt ratio does not consider immediate profitability: it is a balance sheet approach of long-
term debt-paying ability
- Debt ratio relates all liabilities to book value of total assets: many assets may have a market
value higher than book value

Debt to tangible net worth:

- The ratio relates total liabilities to the equity less intangible assets. The lower the ratio, the
lower the proportion of tangible assets financed by creditors. Lower ratios are preferred.
- Relatively stable ratio around 81%: creditors have financed 81% as much as shareholders
after eliminating intangibles. The ratio could be considered as reasonable.
- More conservative than debt ratio
- Same limitations as debt ratio: balance sheet approach only+ most assets are at book value

Overall: reasonable and stable debt ratio and debt to tangible net worth and improving times
interest earned: the long-term debt position is strengthened over the covered time period.

However, we should also analyze profitability trends, industry ratios…

b. In general, ratio analysis should be integrated in a more comprehensive approach which
involves industry and market analysis and which uses other information about the company
products, competitive advantage, management…
Comparison with industry averages is also important as well the determination of the relative
firm position with respect to the median, upper quartile or lower quartile.
Ratio analysis is based on past data to infer the future: future uncertainty cannot be entirely
captured through ratio analysis.
Off-balance sheet risk may not be captured through ratio analysis.

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4 The financial statements of the company L’Accumulateur Tunisien ASSAD on December 31, 2022
are available on the following link:

https://www.cmf.tn/sites/default/files/pdfs/emetteurs/informations/rapports-societes/
assad_efd311222.pdf

Required: Comment on Note X related to the off-balance sheet risk (Engagements hors-bilan).

Answer:

Based on the related note, the company has substantial off-balance sheet risk related to its long-term
debt. The note lists in detail the different mortgages on land, property and equipment as well as the
pledging of business assets in favor of different banking institutions as guarantees for the bank loans
obtained by the company.