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Chapter 7 Long-Term Debt-Paying Ability PROBLEMS PROBLEM 71 Earnings before interest and tax: Net sales $1,079,143 Cost of sales ( 792,755) Selling and administration ( 264,566) $ 21,822 a. b. Cash basis times interest earned: PROBLEM 72 Recurring Earnings Excluding Interest Expense, Tax Expense, Equity Earnings, a. Times Interest Earned = and Minority Earnings Interest Expense, Including Capitalized Interest Income before income taxes $675 Plus interest 60 Adjusted income $735 Interest expense $ 60 Times Interest Earned = $735 = 12.25 times per year $60 13 b.  Adjusted income from (part a) $735 1/3 of operating lease payments (1/3 x $150) 50 Adjusted income, including rentals $785 Interest expense $ 60 1/3 of operating lease payments 50 $110 Fixed Charge Coverage = $785 = 7.14 times per year $110 PROBLEM 73 Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earning, a. Times Interest Earned = and Minority Earnings________________ Interest Expense, Including Capitalized Interest Income before income taxes and extraordinary charges $36 Plus interest 16 (1) Adjusted income 52 (2) Interest expense $16 Times Interest Earned: (1) divided by (2) = 3.25 times per year Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings, and Minority Earnings + Interest Portion b. Fixed Charge Coverage = Of Rentals______________________________ Interest Expense, Including Capitalized Interest + Interest Portion Of Rentals Adjusted income (part a) $ 52 1/3 of operating lease payments (1/3 x $60) 20 (l) Adjusted income, including rentals $72 Interest expense $16 1/3 of operating lease payments 20 (2) Adjusted interest expense $36 Fixed charge coverage: (1) divided by (2) = 2.00 times per year PROBLEM 74 a. Debt Ratio = b. Debt/Equity Ratio = c. Ratio of Total Debt to Tangible Net Worth = Total Liabilities = $174,979 = $174,979 = 70.9% Tangible Net Worth $249,222  $2,324 $246,898 d. Kaufman Company has financed over 41% of its assets by the use of funds from outside creditors. The Debt/Equity Ratio and the Debt to Tangible Net Worth Ratio are over 70%. Whether these ratios are reasonable depends upon the stability of earnings. PROBLEM 7-5 Ratio Transaction Times Interest Earned Debt Ratio Debt/ Equity Total Debt/ Tangible Net Worth a. Purchase of buildings financed by mortgage b. Purchase inventory on short-term loan c. Declaration and payment of cash dividend d. Declaration and payment of stock dividend e. Firm increases profits by cutting cost of sales f. Appropriation of retained earnings g. Sale of common stock h. Repayment of long-term bank loan i. Conversion of bonds to common stock j. Sale of inventory at greater than cost - - 0 0 + 0 0 + + + + + + 0 - 0 - - - - + + + 0 - 0 - - - - + + + 0 - 0 - - - -  PROBLEM 76 a. Times Interest Earned: Times interest earned relates earnings before interest expense, tax, minority earnings, and equity income to interest expense. The higher this ratio, the better the interest coverage. The times interest earned has improved materially in strengthening the longterm debt position. Considering that the debt ratio and the debt to tangible net worth have remained fairly constant, the probable reason for the improvement is an increase in profits. The times interest earned only indicates the interest coverage. It is limited in that it does not consider other possible fixed charges, and it does not indicate the proportion of the firms resources that have come from debt. Debt Ratio: The debt ratio relates the total liabilities to the total assets. The lower this ratio, the lower the proportion of assets that have been financed by creditors. For Arodex Company, this ratio has been steady for the past three years. This ratio indicates that about 40% of the total assets have been financed by creditors. For most firms, a 40% debt ratio would be considered to be reasonable. The debt ratio is limited in that it relates liabilities to the book value of total assets. Many assets would have a value greater than book value. This tends to overstate the debt ratio and, therefore, usually results in a conservative ratio. The debt ratio does not consider immediate profitability and, therefore, can be misleading as to the firm’s ability to handle longterm debt. Debt to Tangible Net Worth: The debt to tangible net worth relates total liabilities to shareholders equity less intangible assets. The lower this ratio, the lower the proportion of tangible assets that has been financed by creditors. Arodex Company has had a stable ratio of approximately 81% for the past three years. This indicates that creditors have financed 81% as much as the shareholders after eliminating intangibles from the shareholders contributionfor most firms, this would be considered to be reasonable. The debt to tangible net worth ratio is more conservative than the debt ratio because of the elimination of intangible items. It is also conservative for the same reason that the debt ratio was conservative, in that book value is used for the assets and many assets have a value greater than book value. The debt to tangible net worth ratio also does not consider immediate profitability and, therefore, can be misleading as to the firms ability to handle longterm debt. Collective inferences one may draw from the ratios of Arodex, Company: Overall it appears that Arodex Company has a reasonable and improving longterm debt position. The debt ratio and the debt to tangible net worth ratios indicate that the proportion of debt appears to be reasonable. The times interest earned appears to be reasonable and improving. The stability of earnings and comparison with industry ratios will be important in reaching a conclusion on the longterm debt position of Arodex Company. b. Ratios are based on past data. The future is what is important, and uncertainties of the future cannot be accurately determined by ratios based upon past data. Ratios provide only one aspect of a firms long-term debt-paying ability. Other information, such as information about management and products, is also important. A comparison of this firms ratios with ratios of other firms in the same industry would be helpful in order to decide if the ratios are reasonable. PROBLEM 77 Recurring Earnings, Excluding Interest a. 1. Times Interest Expense, Tax Expense, Equity Earnings, Earned = and Minority Earnings_________________ Interest Expense, Including Capitalized Interest $162,000 = 8.1 times per year $ 20,000 2. Debt Ratio = Total Liabilities Total Assets $193,000 = 32.2% $600,000 3. Debt/Equity Ratio = Total Liabilities Stockholders Equity $193,000 = 47.4% $407,000  4. Debt to Tangible Net Worth Ratio = Total Liabilities Tangible Net Worth $193,000 = 49.9% $407,000  $20,000 b. New asset structure for all plans: Assets Current assets $226,000 Property, plant, and equipment 554,000 Intangibles 20,000 Total assets $800,000 Liabilities and Equity Plan A Current Liabilities $ 93,000 $200,000,000/100 = Longterm debt 100,000 2,000,000 shares Preferred stock 250,000 Common equity 357,000 No change in net income $800,000 Plan B Current liabilities $ 93,000 $200,000,000/10 = Longterm debt 100,000 20,000,000 shares Preferred stock 50,000 Common stock 120,000 Premium on common stock 300,000 Retained earnings 137,000 No change in net income $800,000 Plan C Current liabilities $ 93,000 Operating Income $162,000 Longterm debt 300,000 Interest expense 52,000* Preferred stock 50,000 110,000 Common equity 357,000 Taxes (40%) 44,000 $800,000 Net Income $ 66,000 * $20,000 + 16% ($200,000) = $52,000 1. Recurring Earnings, Excluding Interest Expense, Times Interest Tax Expense, Equity Earnings, and Minority Earnings Earned = Interest Expense, Including Capitalized Interest Plan A Plan B Plan C 2. Debt = Total Liabilities Ratio Total Assets Plan A Plan B Plan C 3. Debt/Equity Ratio = Plan A Plan B Plan C 4. Debt to Tangible Net Worth = Plan A Plan B Plan C c. Preferred Stock Alternative: Advantages: 1. Lesser drop in earnings per share than under the common stock alternative. 2. Not the absolute reduction in earnings that accompanied the debt alternative. 3. There would be an improvement in the Debt Ratio, Debt/Equity Ratio, and Total Debt to Tangible Net Worth Ratio. 4. Does not have the reduced times interest earned that accompanied alternative of issuing longterm debt. Disadvantages: 1. An increase in the fixed preferred dividend charge that the firm must pay before any dividends can be paid to common stockholders. Common Stock Alternative: Advantages: 1. No increase in fixed obligations. 2. There would be an improvement in the Debt Ratio, Debt/Equity Ratio, and the Total Debt to Tangible Net Worth Ratio. 3. Not the absolute reduction in earnings that accompanied the debt alternative. 4. Does not have the reduced times interest earned that accompanied alternative of issuing longterm debt. Disadvantages: 1. Maximum dilution in earnings per share of the three alternatives. Long-Term Bonds Alternative: Advantages: 1. Higher earnings per share than with common stock. Disadvantages: 1. Material decline in Times Interest Earned. 2. A material increase in the Debt Ratio, Debt/Equity Ratio, and Total Debt to Tangible Net Worth Ratio. 3. Absolute reduction in earnings. 4. Increase in the interest fixed charge that must be paid. d. The 10% preferred stock increased the preferred dividends which are not tax deductible; therefore, the cost of these funds is the 10% amount. The 16% bonds are tax deductible and, therefore, the after-tax cost is 9.6% (16% x (1.40). Note to Instructor: You may want to take this opportunity to point out to the students that the alternative that should be selected is greatly influenced by the change in earnings and the specific debt structure. The conclusions in this problem would not necessarily be true with changed assumptions. PROBLEM 78 a. Times Interest Earned = Earnings from continuing operations before income taxes and equity earnings (1) Add back interest expense (1) $ 74,780,000 (2) Adjusted earnings (2) $ 37,646,000 $112,426,000 Times interest earned: [(2) divided by (1)] 1.99 times per year b. Earnings from continuing operations Plus: (1) Interest $ 65,135,000 Income taxes 37,394,000 (2) Adjusted earnings $140,175,000 Times interest earned: [(2) divided by (1)] 3.72 times per year c. Removing equity earnings gives a more conservative times interest earned ratio. The equity income is usually substantially more than the cash dividend received from the related investments. Therefore, the firm cannot depend on this income to cover interest payments. PROBLEM 79 a. 1. Times Interest Earned = 2. Debt Ratio = 3. Debt Equity =  4. Debt to Tangible Net Worth = b. No, Barker Company has a times interest earned of 5.3 times while the industry average is 7.2 times. This indicates that Barker Company has less than average coverage of its interest. Also, Barker Company has a much higher than average debt/equity, and debt to tangible net worth ratio. c. Allen Company has a better times interest earned, debt ratio, debt/equity, and debt to tangible net worth. PROBLEM 7-10 a. 1. Times Interest Earned = 2004: $280,000 - $156,000 = 7.29 times per year $17,000 2003: $302,000 - $157,000 = 9.06 times per year $16,000 2002: $286,000 - $154,000 = 8.80 times per year $15,000 2001: $270,000 - $150,000 = 8.28 times per year $14,500 2000: $248,000 - $147,000 = 4.39 times per year $23,000  Recurring Earnings, Excluding Interest, Tax Expense, Equity Earnings, and Minority Earnings + 2. Fixed Charge Coverage = Interest Portion of Rentals Interest Expense, Including Capitalized Interest + Interest Portion of Rentals 2004: $280,000 - $156,000 + $10,000 = 4.96 times per year $17,000 + $10,000 2003: $302,000 - $157,000 + $9,000 = 6.16 times per year $16,000 + $9,000 2002: $286,000 - $154,000 + $9,500 = 5.78 times per year $15,000 + $9,500 2001: $270,000 - $150,000 + $10,000 = 5.31 times per year $14,500 + $10,000 2000: $248,000 - $147,000 + $9,000 = 3.44 times per year $23,000 + $9,000 3. Debt Ratio = Total Liabilities Total Assets 2004: $88,000 + $170,000 = 46.07% $560,000 2003: $89,500 + $168,000 = 46.48% $554,000 2002: $90,500 + $165,000 = 46.14% $553,800 2001: $90,000 + $164,000 = 46.31% $548,500 2000: $91,500 + $262,000 = 65.83% $537,000  4. Debt/Equity = Total Liabilities Shareholders Equity 2004: $88,000 + $170,000 = 85.43% $302,000 2003: $89,500 + $168,000 = 86.85% $296,500 2002: $90,500 + $165,000 = 85.65% $298,300 2001: $90,000 + $164,000 = 86.25% $294,500 2000: $91,500 + $262,000 = 192.64% $183,500 5. Debt to Tangible Net Worth = Total Liabilities Shareholders Equity - Intangible Assets 2004: $88,000 + $170,000 = 91.49% $302,000 - $20,000 2003: $89,500 + $168,000 = 92.46% $296,500 - $18,000 2002: $90,500 + $165,000 = 90.83% $298,300 - $17,000 2001: $90,000 + $164,000 = 91.20% $294,500 - $16,000 2000: $91,500 + $262,000 = 209.79% $183,500 - $15,000 b. Both the times interest earned and the fixed charge coverage are good. The times interest earned is substantially better than the fixed charge coverage because of the operating leases. Both of these ratios materially declined in 2004. The debt ratio, debt/equity, and debt to tangible net worth materially improved between 2000 and 2001. During the period 2001-2004, these ratios were relatively steady and appeared to be good. The debt to tangible net worth ratio is not as good as the debt/equity ratio because of the influence of intangibles.