Income Statement Consideration When Determining Long-Term Debt-Paying Ability

Income Statement Consideration When Determining Long-Term Debt-Paying Ability

7-1

Chapter 7

Long-Term Debt-Paying Ability

Income Statement Consideration when Determining Long-Term Debt-Paying Ability

Times Interest Earned

Indicates a firm’s long-term debt-payingability from the income statement view

A strong ratio enhances the firm’s ability to refinance debt and obtain financing at a favorable rate

A short-run perspective of this ratio adds noncash expenses such as depreciation back to the numerator

Nike, Inc.: Times Interest Earned

Nike, Inc.: Times Interest Earned (Short-Run Perspective)

Fixed Charge Coverage

An extension of the times interest earned ratio

Indicates a firm’s ability to cover fixed charges

The SEC’s ratio of earnings to fixed changes includes a portion of operating leases in the fixed charges

Nike, Inc.: Fixed Charge Coverage

Balance Sheet Consideration when Determining Long-Term Debt-Paying Ability

Debt Ratio

Reserves

Appear on the balance sheet under liabilities but are not a liability per se

Represent an estimate of future payout rather than a commitment to pay

Included in the debt ratio

Deferred Taxes (Interperiod Tax Allocation)

The difference between income tax expense and income taxes payable

Recognized as a liability (asset)

  • May be disclosed as a current asset, long-term asset, current liability, or long-term liability

Included in the debt ratio

Minority Shareholders’ Interest

Represents the equity interest of minority shareholders of an entity that is a less-than-100%-owned subsidiary of another firm

Not a liability, but included in the debt ratio for a conservative calculation

Redeemable Preferred Stock

Subject to redemption requirements not controlled by the issuing company

Not a liability and may be excluded from the debt ratio or included for a more conservative calculation

Debt/Equity Ratio

Helps determine how well creditors are protected in case of insolvency

Conservative application includes all liabilities and near liabilities

Nike, Inc.: Debt/Equity Ratio

Debt to Tangible Net Worth Ratio

Determines the entity’s long-term debt-paying ability

Indicates how well creditors are protected in case of the firm’s insolvency

Nike, Inc.: Debt to Tangible Net Worth Ratio

Other Long-Term Debt-Paying Ability Ratios

Current debt/net worth ratio

Total capitalization ratio

Fixed asset/equity ratio

Special Items that Influence a Firm’s Long-Term Debt-Paying Ability

Long-Term Assets versusLong-Term Debt

Assets are the backing of long-term debt

Although not frequently disclosed in financial statements, the fair value of the assets may be used to satisfy long-term debt

Substantial assets that have a potential value higher than book may also indicate an earnings potential to be realized later

Long-Term Leasing

Capital-lease assets and the associated liability are reported on the balance sheet

  • The carrying amount of these items will not necessarily agree

The asset carrying value is reduced by depreciation

The carrying value of the debt is reduced by periodic payments

Operating-lease assets are not recorded nor are liabilities posted for the contractual obligation

  • Disclosure is made in the notes of the minimum future rentals
  • For supplemental debt ratio analysis, an approximation of the principle portion of these payments should be added to fixed assets and long-term liabilities

Pension Plans

Defined contribution plan

  • Defines the contributions of the company
  • Shifts the risk of achieving the desired pension value to the employee

Defined benefit plan

  • Defines the benefits to be received by the plan participants
  • The risk of accumulating a plan sufficient to support the defined retirement benefits is shifted to the employer

Current GAAP requires significant financial statement disclosure to the plans including assumptions for discount rate, rate of compensation increase, and expected return on assets

Kellogg Company: Pension Benefits

Postretirement Benefits Other than Pensions

Obligations of employers to retired employees covering benefits such as health and life insurance may be substantial

  • Accrual was not mandated prior to 1993

The transition costs to accrual accounting may be amortized over 20 years

Winnebago: Postretirement Health Care and Deferred Compensation Benefits

Joint Ventures

An association of two or more businesses established for a special purpose

Commitments to unconsolidated entities may give rise to unrecognized potential liabilities

Contingencies

An existing condition with an uncertain ultimate effect whose resolution will depend on one or more future events.

Loss contingencies are accrued if:

  • It is probable that an asset has been impaired or a liability incurred
  • The amount of the eventual loss can be reasonably estimated

If one but not both of the criteria for accrual are met, the loss is reported in the notes

Gain contingencies are not accrued but may be disclosed in the notes

  • Care is taken to avoid misleading implications

Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk

Specific disclosures are required for financial instruments with off-balance-sheet risk

Credit risk concentration disclosure is also required

Nordson Corporation: Off-Balance-Sheet Risk and Concentrations of Credit Risk

Disclosures about Fair Value of Financial Instruments

The fair value of financial instruments—assets and liabilities both reported on the balance sheet and those not recognized—is disclosed

Northrop Grumman: Fair Value of Financial Instruments

Top View