Previous Lecture Summary

2. Previous Lecture Summary • Long Term Debt-Paying Ability • Income Statement Consideration when • Determining Long-Term Debt-Paying Ability • Times interest earned • Fixed charge coverage

3. Today's Lecture Topics • Long Term Debt-Paying Ability • Practical Exercises • Balance Sheet Consideration when Determining Long- Term Debt-Paying Ability, • Debt Ratio, Debt/Equity Ratio, Debt to Tangible net worth ratio, • Other Long-Term Debt-Paying Ability Ratios, Special Items that Influence a • Firm’s Long-Term Debt-Paying Ability, • Long – Term Assets Versus Long Term Debt, Long term leasing, • Pension Plans, Postretirement Benefits Other than Pensions,

4. Practical Exercise Consider the following operating figures Net sales $1,079,143 Cost and deductions Cost of sales 792,755 Selling and administration 264,566 Interest expense, net 4,311 Income taxes 5,059 $1,066,691 $ 12,452 Note depreciation expense totals $40,000. Required: a. Compute the time interest earned b. Compute the cash basis time interest earned

7. Practical Exercise Calculate the times interest earned ratio of a company having interest expense and earnings before interest and tax for the year ended Dec 31, 2010 of $239,000 and $3,493,000 respectively.

9. Practical Exercise The times interest earned ratio and earnings before interest and tax of a company were 9.34 and $1,324,400 during the year ended Jun 30, 2011. Calculate the interest expense of the company.

11. Practical Exercise The Sherwill statement of consolidated income is as follows Net sales $658 Other Income 8 666 Cost and expenses: Cost of products sold 418 Selling, general, and administrative expense 196 Interest 16 Income before income taxes and Extraordinary charges 36 Income taxes 18 Income before extraordinary charge 18 Extraordinary charge-losses on tornado damage (net) 4 Net Income $14 Note: Depreciation expense totals$200; operating lease payment Total $60; and preferred dividends total$50. Assume that 1/3 of Operating lease payments is for interest. Required: a. Compute the time interest earned b. Compute the fixed charge coverage

15. Laura Bella Company reports the following statement of income: Note: Depreciation expense totals $300; preferred dividends total $60; operating lease payments total $180. Assume that 1/3 of operating lease payments is for interest. Required:

18. ABC Bank reported the following comparative income figures in 2010. Your boss, the president of ABC bank, is concerned about ABC borrowings capacity. A representative of ABC feels that there should be no problem, since net income are the same with slightly higher sales. Required: Compute times interest earned and comment on the bank's position.

20. Debt Ratio • Indicates the percentage of assets financed by creditors • Comparisons • Industry competitors and averages • Variations in application • Short-term liabilities • Not part of long-term source of funds: exclude • Part of the total source of funds: include • Liabilities that do not necessarily represent a commitment to pay out funds in the future

21. Debt Ratio and Certain Liabilities • Reserves • Matches an expense but is not a liability • Infrequently used in U.S. GAAP statements • Include in ratio for conservative application • Deferred Income Taxes • Difference between income tax expense and income taxes payable • Commonplace in U.S. GAAP statements • Recognized as a liability by GAAP; include in ratio

22. Debt Ratio and Certain Liabilities (cont’d) • Minority Shareholders’ Interest • Proportion of a consolidated entity that is not owned by the controlling parent company • Not a liability • Include in ratio for conservative application • Redeemable Preferred Stock • Exclude from ratio; does not present a normal debt relationship • Include in ratio for conservative application

23. Debt/Equity Ratio • Helps determine how well creditors are protected in case of insolvency • Comparisons • Industry competitors and averages

24. Debt to Tangible Net Worth 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

25. Other Long-Term Debt-Paying Ability Ratios • Current debt/net worth ratio • The relationship between current liabilities and funds contributed by shareholders • Total capitalization ratio • Compares long-term debt to total capitalization • Total capitalization: long-term debt, preferred stock, and common stockholders’ equity • Fixed asset/equity ratio • The extent to which shareholders have provided funds in relation to fixed assets

26. Long-Term Assets vs. Long-Term Debt • 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 than carrying value • Certain assets may have earnings potential in the future

27. Long-Term Leasing • 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

28. Pension Plans • Employee Retirement Income Security Act (ERISA) • Includes provisions requiring • Minimum funding of plans • Minimum rights to employees upon termination of their employment • Creation of the Pension Benefit Guaranty Corporation

29. Defined Contribution Plan • Contributions to the plan are specified • Employer bears no risk for future growth of plan • No complex expense or liability issues • 401K 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

30. Defined Benefit Plan • Defines the benefits to be received • Employer must fund sufficiently to achieve benefit • Note actuarial assumptions inherent in the plan • Interest (discount) rates • Employee turnover • Mortality rates • Compensation • Pension benefits

31. Defined Benefit Plan (cont’d) • Compare three years of • Pension expense in relationship to operating revenue and income before income taxes • Compare benefit obligations to plan assets • Underfunded: a potential liability • Overfunded: potential opportunities to reduce future pension expense and/or reduce related costs

32. Defined Benefit Plan (cont’d) • Consider employer’s pension-related assumptions and the effect that changes in the assumptions will have on recognized and off-balance-sheet pension accounts • Interest (discount) rate • Rate of compensation increase • Expected return on plan assets

33. Postretirement BenefitsOther than Pensions • 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 pension • Exception: no rate of compensation increase

34. Lecture Summary • Long Term Debt-Paying Ability • Balance Sheet Consideration when Determining • Long-Term Debt-Paying Ability, • Debt Ratio, Debt/Equity Ratio, Debt to Tangible net • worth ratio, • Other Long-Term Debt-Paying Ability Ratios, Special • Items that Influence a • Firm’s Long-Term Debt-Paying Ability,

35. Long – Term Assets Versus Long Term Debt, Long • term leasing, • Pension Plans, Postretirement Benefits Other than • Pensions,