Week 3

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Chapter 7

Long-Term Debt-Paying Ability

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

Times Interest Earned

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

Times Interest Earned—Continued

Times Interest Earned- Short-Run Variation

Indicates a firm’s ability to cover fixed charges

Fixed Charge Coverage

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

Fixed Charge Coverage—Continued

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

Debt Ratio

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

Debt Ratio—Continued

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

Debt Ratio and Certain Liabilities

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

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

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

Debt Ratio and Certain Liabilities—Continued

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

Debt/Equity 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

Debt to Tangible Net Worth Ratio

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

Other Long-Term Debt-Paying Ability Ratios

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

Other Long-Term Debt-Paying Ability Ratios—Continued

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

Long-Term Assets versus Long-Term Debt

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

Long-Term Leasing

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)

Pension Plans

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

Defined Contribution 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

Defined Benefit Plan

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

Defined Benefit Plan—Continued

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

Postretirement Benefits Other than Pensions

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

Joint Ventures

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

Contingencies

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

Financial Instruments with Off-Balance-Sheet 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

Financial Instruments with Concentrations of Credit Risk

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

Disclosures About Fair Value of Financial Instruments

Recurring Earnings, Excluding Interest

Expense, Tax Expense, Equity Earnings,

and Noncontrolling Interest

Times Interest Earned =

Interest Expense, Including Capitalized

Interest

(Recurring Earnings + Noncash Expense),

Excluding Interest Expense, Tax Expense,

Equity Earnings, and Noncontrolling Inte

rest

Times Interest Earned =

Interest Expense, Including Capitalized

Interest

Recurring Earnings, Excluding Interest

Expense, Tax Expense, Equity Earnings,

and Noncontrolling Interest + Interest

Portion of Rentals

Fixed Charge Coverage =

Interest Expense, Including Capitalized

terest + Interest Portion of Rentals

Total Liabilities

Debt Ratio =

Total Assets

Total Liabilities

Debt/Equity Ratio =

Shareholders' Equity

Total Liabilitites

Debt to Tangible Net Worth Ratio =

Shareholders' Equity Intangible Assets