CHAPTER 7 Balance Sheet Consideration when Determining Long-Term Debt-Paying Ability
The firm’s ability to carry debt, as indicated by the balance sheet, can be
Long-Term Debt-Paying Ability
This chapter covers two approaches to viewing a firm’s long-term debt-
paying ability. One approach views the firm’s ability to carry the debt as indicated by
the income statement, and the other considers the firm’s ability to carry debt as
indicated by the balance sheet.
In addition to the profitability of the firm, the amount of debt in relation to
the size of the firm should be analyzed. This analysis indicates the amount of funds
provided by outsiders in relation to those provided by owners of the firm. If a high
proportion of the resources has been provided by outsiders, the risks of the
business have been substantially shifted to the outsiders. A large proportion of debt
in the capital structure increases the risk of not meeting the principal or interest
obligation because the company may not generate adequate funds to meet these
obligations.
Income Statement Consideration when Determining Long-Term Debt-Paying
Ability
The firm’s ability to carry debt, as indicated by the income statement, can
be viewed by considering the times interest earned and the fixed charge coverage.
Times interest earned ratio indicates a firm’s long-term debt-paying ability from the
income statement view, the higher the ratio the more easily the company can meet
its interest expense as they come due.
A company issues debt obligations to obtain funds at an interest rate less
than the earnings from these funds. This is called trading on the equity or leverage.
With a high interest rate, the added risk exists that the company will not be able to
earn more on the funds than the interest cost on them.
Time interest earned= Income before income taxes & Interest Expense
Interest Expense
FIXED CHARGE COVERAGE
The fixed charge coverage ratio, an extension of the times interest earned ratio, also
indicates a firm’s long-term debt-paying ability from the income statement view. The
fixed charge coverage ratio indicates a firm’s ability to cover fixed charges.
viewed by considering the debt ratio and the debt/equity ratio.
The debt ratio indicates the firm’s long-term debt-paying ability. It is
computed as follows: Debt Ratio =Total Liabilities
Total Assets
Reserves
The reserve accounts classified under liabilities (some short-term and
some long-term) result from an expense charge to the income statement and
an equal increase in the reserve account on the balance sheet. These reserve
accounts do not represent definite commitments to pay out funds in the
future, but they are estimates of funds that will be paid out.
Reserve accounts are used infrequently in U.S. financial reporting. It is
thought that they provide too much discretion in determining the amount of
the reserve and the related impact on reported income. When the reserve
account is increased, income is reduced. When the reserve account is
decreased, income is increased. Reserve accounts are popular in some other
countries like Germany.
Minority Shareholders’ Interest
The account, minority shareholders’ interest, results when the firm has
consolidated another company of which it owns less than 100%. The
proportion of the consolidated company that is not owned appears on the
balance sheet just above stockholders’ equity. Some firms exclude the minority
shareholders’ interest when computing debt ratios because this amount does
not represent a commitment to pay funds to outsiders. Other firms include the
minority shareholders’ interest when computing debt ratios because these
funds came from outsiders and are part of the total funds that the firm uses.
This book takes the conservative position of including minority shareholders’
interest in the primary computation of debt ratios.
Redeemable Preferred Stock
Redeemable preferred stock is subject to mandatory redemption requirements
or has a redemption feature outside the control of the issuer. Some
redeemable preferred stock agreements require the firm to purchase certain
amounts of the preferred stock on the open market. The Securities and
Exchange Commission dictates that redeemable preferred stock not be
disclosed under stockholders’ equity.
DEBT /EQUITY RATIO Special Items That Influence a Firm’s Long-Term Debt-Paying Ability

The debt/equity ratio is another computation that determines the entity’s

long-term debt paying ability. This computation compares the total debt with the
total shareholders’ equity. The debt/equity ratio also helps determine how well
creditors are protected in case of insolvency. From the perspective of long-term
debt-paying ability, the lower this ratio is, the better the company’s debt position.

Debt /Equity Ratio = Total Liabilities

Shareholders’ Equity

DEBT TO TANGIBLE NET WORTH RATIO

The debt to tangible net worth ratio also determines the entity’s long-term
debt-paying ability. This ratio also indicates how well creditors are protected in
case of the firm’s insolvency. As with the debt ratio and the debt/equity ratio,
from the perspective of long-term debt-paying ability, it is better to have a lower
ratio. The debt to tangible net worth ratio is a more conservative ratio than either
the debt ratio or the debt/equity ratio. It eliminates intangible assets, such as
goodwill, trademarks, patents, and copyrights, because they do not provide
resources to pay creditors—a very conservative position.

Debt to Tangible Net Worth Ratio = Total Liabilities

Shareholders’ Equity − Intangible Assets

OTHER LONG -TERM DEBT PAYING ABILITY RATIOS

The 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.

Another ratio, the total capitalization ratio, compares long-term debt to total
capitalization. Total capitalization consists of long-term debt, preferred stock, and
common stockholders’ equity. The lower the ratio, the lower the risk.

Another ratio, the fixed asset/equity ratio, indicates the extent to which
shareholders have provided funds in relation to fixed assets. Some firms subtract
intangibles from shareholders’ equity to obtain tangible net worth. This results in
a more conservative ratio. The higher the fixed assets in relation to equity, the
greater the risk.