Long-Term Debt-Paying Ability 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 © 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 (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.

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.

Fixed Charge Coverage 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.

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.

Debt Ratio 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.

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.

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 © 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.

Debt/Equity Ratio 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.

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 © 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.

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.

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.

Long-Term Leasing Capital leases Operating 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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.