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 Chapter
7

Long-Term
Debt-Paying Ability

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Times Interest Earned
• Indicates long-term debt-paying ability
• Consider only recurring income
– Exclude discontinued operations
– Exclude extraordinary items
• Exclude (add back) to income
– Interest and Income tax expenses
– Equity losses (earnings) of nonconsolidated
subsidiaries
– Net income—Noncontrolling interest
• Include interest capitalized
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Times Interest Earned—Continued

Recurring Earnings, Excluding Interest

Expense, Tax Expense, Equity Earnings,
and Noncontrolling Interest
Times Interest Earned =
Interest Expense, Including Capitalized
Interest

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Times Interest Earned—Continued
• 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
• Short-run coverage
– Add back noncash expenses to recurring income
– Less conservative

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Times Interest Earned- Short-Run
Variation

(Recurring Earnings + Noncash Expense),

Excluding Interest Expense, Tax Expense,
Equity Earnings, and Noncontrolling Interest
Times Interest Earned =
Interest Expense, Including Capitalized Interest

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 Fixed Charge Coverage
• Indicates a firm’s ability to cover fixed charges

Recurring Earnings, Excluding Interest

Expense, Tax Expense, Equity Earnings,
and Noncontrolling Interest + Interest
Portion of Rentals
Fixed Charge Coverage =
Interest Expense, Including Capitalized
Interest + Interest Portion of Rentals

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Fixed Charge Coverage—Continued
• Fixed charges include
– Interest portion of operating lease payments
• General approximation is to include 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
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Debt Ratio
• Indicates the firm’s long-term debt-paying ability
• Total liabilities
– Includes short-term liabilities, reserves, deferred tax
liability, noncontrolling interests, redeemable preferred
stock, and any other non current liability
• Indicates the percentage of assets financed by
creditors
Total Liabilities
Debt Ratio =
Total Assets

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Debt Ratio—Continued
• Comparisons
– Competitors and industry averages
• Variations in application
– Short-term liabilities
• Exclude as they are not part of long-term source of funds
• Include as they become part of the total source of funds
– Liabilities that do not necessarily represent a
commitment to pay out funds in the future

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Debt Ratio and Certain Liabilities
• Reserves
– Matches an expense but do not represent definite
commitments to pay out funds in the future
– Infrequently used in U.S. GAAP statements
– Include in ratio for conservative application

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Debt Ratio and Certain Liabilities—
Continued
• Deferred Income Taxes
– Difference between income tax expense and income
taxes payable
– Recognized as a liability by GAAP; include in ratio
– A company reports deferred taxes as
• A net current amount
• A net noncurrent amount
– Referred as soft accounts

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Debt Ratio and Certain Liabilities—
Continued
• 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
– Some firms exclude from ratio as it does not
represent a commitment to pay funds to outsiders
– Included in ratio for conservative application

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Debt Ratio and Certain Liabilities—
Continued
• Redeemable Preferred Stock
– Not disclosed under stockholders’ equity
– Exclude from ratio; does not present a normal debt
relationship
– Included in ratio for conservative application

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Debt/Equity Ratio
• Determines the entity’s long-term debt-paying
ability
• Helps determine how well creditors are
protected in case of insolvency
• Comparisons
– Competitors and industry averages

Total Liabilities
Debt/Equity Ratio =
Shareholders' Equity

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Debt to Tangible Net Worth Ratio
• 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

Total Liabilitites
Debt to Tangible Net Worth Ratio =
Shareholders' Equity  Intangible Assets

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Other Long-Term Debt-Paying Ability
Ratios
• Current debt/net worth ratio
– Indicates a relationship between current liabilities and
funds contributed by shareholders
– The higher the proportion of funds provided by current
liabilities, the greater the risk
• Total capitalization ratio
– Compares long-term debt to total capitalization
– Total capitalization consist of long-term debt,
preferred stock, and common stockholders’ equity
– The lower the ratio, the lower the risk

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Other Long-Term Debt-Paying Ability
Ratios—Continued
• Fixed asset/equity ratio
– The extent to which shareholders have provided
funds in relation to fixed assets
– Subtracting intangibles from shareholders’ equity will
result in more conservative ratio
– The higher the fixed assets in relation to equity, the
greater the risk

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Long-Term Assets versus 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

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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

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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 a special federal agency, the Pension Benefit
Guaranty Corporation (PBGC)

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Defined Contribution Plan
• Defines the contributions of the company to the
pension plan
• Employer bears no risk for future growth of plan
• No complexity in estimating company’s pension
liability or pension expense
• 401(k) 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; note any balance sheet items
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Defined Benefit Plan
• Defines the benefits to be received by the
participants in the plan
• Employer must fund sufficiently to achieve
benefit
• Note actuarial assumptions inherent in the plan
– Interest (discount) rates
– Employee turnover
– Mortality rates
– Compensation
– Pension benefits
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Defined Benefit Plan—Continued
• Trend analysis
– Compare three years of pension expense in
relationship to operating revenue and income before
income taxes
• Compare benefit obligations to plan assets
– Underfunding represents a potential liability
– Overfunding represents an opportunity to reduce
future pension expense and/or reduce related costs
• Note the net balance sheet liability (asset)
recognized

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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 plans for
pension

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Joint Ventures
• An association of two or more businesses
established for a special purpose
• Consolidation
– Done by the parent firm if it has control using a pro-
rata share
• Carried in an investment account
• Analysis
– Review footnote that relates to the joint venture
– Off-balance sheet commitments represent potential
liabilities

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Contingencies
• An existing condition involving uncertainty as to
possible gain or loss to an enterprise
– Will be resolved when one or more future events
occur or fail to occur
• Loss contingencies that are not accrued are
included in the footnotes
• Gain contingencies are not accrued
– Review contingency note for possible liabilities and
gain contingencies not disclosed on the balance sheet

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Financial Instruments with
Off-Balance-Sheet Risk
• Disclosure is required of
– The face or contract amount
– Nature and terms of the instrument
– Amount of the potential loss
– Entity’s collateral policy and description of the
collateral it currently holds
• Accounting loss occurs when
– The co-party fails to perform the terms of contract
– Changes in market make a instrument less valuable
or more troublesome

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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

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Disclosures About
Fair Value of Financial Instruments
• Disclosure of financial instrument’s 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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