Long-Term Debt-Paying Ability: The Star Logo, and South-Western Are Trademarks Used Herein Under License

Chapter 7
Long-Term
Debt-Paying Ability
COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson,

the Star logo, and South-Western are trademarks used herein under license.
Times Interest Earned
Recurring Earnings, Excluding Interest

Expense, Tax Expense, Equity Earnings,
and Minority Earnings
Interest Expense, Including Capitalized Interest
Chapter 7, Slide #2
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
– Minority loss (income)
• Include interest capitalized
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
• Slightly different analysis
– Interest coverage on long-term debt
– Use only interest on long-term debt
• Not practical for external analysis
Chapter 7, Slide #4
Times Interest Earned
Short-Run Variation
(Recurring Earnings + Noncash Expenses)
Excluding Interest Expense, Tax Expense,
Equity Earnings, and Minority Earnings
• Short-run coverage
– Add back noncash expenses to recurring income
(Depreciation/Gains/Losses)
– Less conservative
Chapter 7, Slide #5
Fixed Charge Coverage
Recurring Earnings, Excluding Interest

Expense, Tax Expense, Equity Earnings,
and Minority Earnings
+ Interest Portion of Rentals
+ Interest Portion of Rentals
• Ratio trend is usually similar to trend of times-

interest-earned ratio
Chapter 7, Slide #6
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
Chapter 7, Slide #7
Debt Ratio
Total Liabilities
Total Assets
• Indicates the percentage of assets financed by creditors
• Comparisons
• Variations in application
– Exclude short-term liabilities if NOT part of long-term source of
funds
– Liabilities that do not necessarily represent a commitment to
pay out funds in the future
Chapter 7, Slide #8
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
Chapter 7, Slide #9
Debt Ratio and Certain Liabilities
(cont’d)
• Minority Shareholders’ Interest

– Proportion of a consolidated entity that is not owned
by the controlling parent company
– Not a liability per se
• Redeemable Preferred Stock
– Exclude from ratio; does not present a normal debt
relationship
Chapter 7, Slide #10

Debt/Equity Ratio
Total Liabilities
Shareholders' Equity
• Helps determine how well creditors are

protected in case of insolvency
• Comparisons

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

Other Long-Term Debt-Paying Ability
Ratios
• Current debt/net worth ratio
– The relationship between current liabilities and
funds contributed by shareholders
• Fixed asset/equity ratio
– The extent to which shareholders have provided
funds in relation to fixed assets

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

Pension Plans
• Employee Retirement Income Security Act

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

1) 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
• Most Companies are going with this type of plan

2) 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

2) 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

2) Defined Benefit Plan (cont’d)
• Consider employer’s pension-related

assumptions and the effect that changes in the
assumptions will have on recognized and off-
balance-sheet pension accounts
– Interest (discount) rate
– Rate of compensation increase
– Expected return on plan assets changes

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

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
– Examples: Viox lawsuits

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

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

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


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Chapter 7

COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson,

Recurring Earnings, Excluding Interest

Recurring Earnings, Excluding Interest

• Ratio trend is usually similar to trend of times-

• Fixed charges include

• Minority Shareholders’ Interest

Chapter 7, Slide #10

• Helps determine how well creditors are

Chapter 7, Slide #11

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

Chapter 7, Slide #12

Chapter 7, Slide #13

Chapter 7, Slide #14

• Employee Retirement Income Security Act

Chapter 7, Slide #15

• Contributions to the plan are specified

Chapter 7, Slide #16

• Defines the benefits to be received

Chapter 7, Slide #17

• Compare three years of

Chapter 7, Slide #18

• Consider employer’s pension-related

Chapter 7, Slide #19

Chapter 7, Slide #20

• Loss contingencies that are not accrued are

Chapter 7, Slide #21

Chapter 7, Slide #22

Chapter 7, Slide #23

• Disclosure of financial instrument fair value is

Chapter 7, Slide #24

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