Today's Lecture Topics

• Chapter Exercises
 Long Term Debt-Paying Ability
• Income Statement Consideration when
Determining Long-Term Debt-Paying
Ability
• Times interest earned
• Fixed charge coverage
 Practical Exercise
J.A. Appliance Company has supplied you with the following data regarding
working capital and sales for the years 2004, 2003, and 2002
2004 2003 2002
Working Capital $270,000 $260,000 $240,000
Sales $650,000 $600,000 $500,000
Industry average for the ratio
Sales to working capital 4.1times 4.05times 4.00times
Required:
•Compute the sales to working capital ratio for each year
•Comment on the sales to working capital ratio for J.A appliance in relation to
the industry average and what this may indicate.
• The sales to working capital ratio for J.A. Appliance Company
was substantially below the industry average for all three
years. This tentatively indicates that working capital is not
efficient in relation to the sales. There was some improvement
in the ratio each year.
 Practical Exercise
Acme Plumbing Company sells plumbing fixtures on terms of 2/10, net 30.
Its financial statements over the last three years are as follows:
Required:
Compute the following Ratios:
1. Current Ratio
2. Acid-Test Raio
3. Average Collection Period
4. Inventory Turnover
5. Total debt/Equity Ratio
6. Gross Profit Margin
7. Net profit Margin
8. Total Assets Turnover
9. Return on Assets
 Chapter overview
• Covers two approaches to viewing a Firm’s long
term debt paying Ability.
– The firm’s ability to carry the debts as indicated by the
income statement
– The firm’s ability to carry debt as indicted by the
balance sheet.
– Long run relationship exist between the reported
income resulting from the use of accrual accounting
and ability to meet long term obligations of firm.
– The amount of debt in relation to size of entity
should be considered.
• The amount of funds provided by outsiders in
relation to those provided by owners of the
firm.
• Resources provided by outsiders is high.. Then
the risk shifted to outsiders.
• Large proportion Debt in Capital structure
increases the risk not meeting the principal on
interest obligation.
 Times Interest Earned
Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Minority Earnings
Interest Expense, Including Capitalized Interest
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
– Minority loss (income)
• Include interest capitalized
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
 Times Interest Earned
Short-Run Variation
(Recurring Earnings + Noncash Expenses)
Excluding Interest Expense, Tax Expense,
Equity Earnings, and Minority Earnings
Interest Expense, Including Capitalized Interest
 Fixed Charge Coverage
Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Minority Earnings
+ Interest Portion of Rentals
Interest Expense, Including Capitalized Interest
+ Interest Portion of Rentals

• Ratio trend is usually similar to trend of

times-interest-earned ratio
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
 Lecture Summary

 Long Term Debt-Paying Ability

• Income Statement Consideration when
Determining Long-Term Debt-Paying Ability
• Times interest earned
• Fixed charge coverage
• Practical Exercise