Finsas 7

LONG-TERM DEBT-PAYING ABILITY

Melvin Osorio

Angie T Ospina

Joselin Ramirez

Danny Repollet

Diamond Foods, Inc.

A company’s ability to pay its long-term debts can be evaluated from the balance sheet items or the income statement items. Some of the ratios used to evaluate long-term debt-payment ability include fixed charge coverage, debt ratio, debt to equity ratio, times interest earned and the debt to tangible net worth ratio. This paper focuses on evaluating Diamond Foods, Inc.’s ability to meet its long-term obligations as well as to explain the cause of the changes in the different ratios.

1. Times Interest Earned

This is a ratio that is used to determine whether the company is able to meet its interest obligations from its earnings. It is also known as the interest coverage ratio. Income statement items are used to calculate the interest coverage ratio after which it is expressed as a number as opposed to a percentage. A higher ratio is usually preferred because it indicates a lesser financial risk to creditors. It is calculated using the formula;

Times Interest earned	=	Recurring earnings excluding interest, tax expense, equity earnings and non-controlling interest
		Interest expense, including capitalized interest

	2011	2010
Net Income	50211	26211
Interest Expense	23840	10180
Tax Expense	18929	13990
Equity Earnings	-	-
Non-controlling Interest	-	-
Numerator	92980	50381

2010

Times Interest earned	=	50381
		10180

=4.95

2011

Times Interest earned	=	92980
		23840

=3.90

Diamond foods were able to cover interest payment 4.95 times in the year 2010 and 3.90 times in the year 2011. The main difference between the two years is that in 2011 the margin for LIBOR loans which used to range between 2.25% to 3.5% was increased to 3.92%. This therefore led to an increase in the interest expense and decreased times interest earned.

2. Fixed Charge Coverage

This is a ratio that evaluates how well a company is able to cover its fixed debt obligations which include the interest payments and lease expenses. The ratios are used by lenders to evaluate whether a company can be able to service more debt given its income. A higher coverage indicates that the company is able to service its debt repayment with ease and hence can afford to get more debt. However, a low coverage ratio indicates that the company is struggling financially and that a fall in its income could lead to a default. It is calculated using the formula;

Fixed Charge Coverage	=	Recurring earnings excluding interest, tax expense, equity earnings and non-controlling interest + Interest portion of rentals
		Interest expense, including capitalized interest + Interest portion of rentals

	2011	2010
Net Income	50211	26211
Interest Expense	23840	10180
Tax Expense	18929	13990
Operating Lease Expense	4900	3200
Equity Earnings	-	-
Non-controlling Interest	-	-
Numerator	97880	53581

2010

Fixed Charge Coverage	=	53581
		10180 + 3200

=4.00

2011

Fixed Charge Coverage	=	97880
		23840 + 4900

=3.41

In the year 2010 the company had a fixed charge ratio of 4.00 while in 2011 it reduced to 3.41. The reasons behind the decrease is that in 2011 both the interest rates and the operating leases increased and thereby making the denominator higher than that of 2010. The analysis goes to show that although the company is still able to cover its fixed debt obligations, its financial strength decreased in the year 2011.

3. Debt Ratio

This is the ratio that measures the leverage of a company. It therefore measures how much of the company’s assets are financed by debt. It is calculate using balance sheet items namely; total liabilities and total assets. A high debt ratio indicates a high financial risk while a low debt ratio indicates a more financially stable company. However, the determination of whether a debt ratio is high or low varies from industry to industry. It is calculated by dividing the total liabilities of a company by its total assets.

Debt Ratio	=	Total liabilities
		Total Assets

	2011	2010
Total Liabilities (a)	833600	845929
Total Assets (b)	1288395	1225872
Debt Ratio (a/b)	64.70%	69.01%

From the calculation above, it can be seen that Diamond Food’s assets are mostly financed by debt because debt makes more than half of its capital. This shows that Diamond is a company that is heavily dependent of debt and hence there is a high financial risk involved when lending to them. It can however be noted that the company decreased its debt levels in 2011 by approximately five percent. The reason behind this is that in 2010 the company used borrowings under the Secured Credit Line Facility to fund its operations and the acquisition of Kettle Foods. However, in 2011 the company closed no acquisition deals therefore it made debt repayments which reduced its gearing level.

4. Debt-Equity Ratio

The debt to equity ratio shows how much debt a company uses compared to equity. It is calculated by dividing total liabilities by the total equity. A debt to equity ratio of 0.5 shows that a company uses twice as much equity than liabilities.

Debt to Tangible Net-Worth Ratio	=	Total liabilities
		Shareholders’ Equity
	2011	2010
Total liabilities (a)	833600	845929
Total Equity (b)	454795	379943
Debt Ratio (a/b)	1.832914	2.226463

From the table above, it can be seen that the company used 2.22 times as much liabilities than equity in 2010 and 1.83 times as much liabilities than equity in 2011. This is a company with a very high financial risk because the liabilities are more than equity. In such a company, in case of defaults the investors might lose their investments. This difference in the ratios was caused by the fact that the company increase equity through its retained earnings therefore the relative proportion of equity to debt increased in 2011.

5. Debt to Tangible Net-Worth Ratio

It is a more conservative way of comparing the company’s liabilities to equity since it excludes unquantifiable intangible assets from shareholder’s equity. The main reason for excluding intangible assets such as goodwill and trademarks is that when a company is insolvent the goodwill might not be worth much. A debt to intangible assets above 1 show that creditors are at risk of losing their money since in case of insolvency, they will only be able to recoup part of their interest and principal amounts. It is calculated using the formula;

Debt to Tangible Net-Worth Ratio	=	Total liabilities
		Shareholders Equity - Intangible assets
	2011	2010
Total Liabilities (a)	833600	845929
Total Equity	454795	379943
Goodwill	-407587	-396788
Other Intangible assets	-450855	-449018
Denominator (b)	-403647	-465863
Debt Ratio (a/b)	-2.06517	-1.81583

From the table it can be seen that the creditors are at a very high risk in case of insolvency since they will not be able to recoup their money from the company. The increase in goodwill in 2011 was as a result of translational adjustments. The difference between the ratios of the two years was cause by the increase in intangible assets.