HUANGHUAI UNIVERSITY & BANGOR UNIVERSITY Lecture 6 Long-Term Debt-Paying Ability DR. AZIZ JAAFAR...
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Transcript of HUANGHUAI UNIVERSITY & BANGOR UNIVERSITY Lecture 6 Long-Term Debt-Paying Ability DR. AZIZ JAAFAR...
HUANGHUAI UNIVERSITY
& BANGOR UNIVERSITY
Lecture 6
Long-TermDebt-Paying Ability
DR. AZIZ JAAFAR
Chapter 6, Slide #1
Long-Term Debt-Paying Ability
• Long-Term Debt – example: Long-term Loan, Bond, Debenture, Mortgage
• Interest expense on long term debt.• Two approaches to view a firm’s long term
debt paying ability:– Income Statement– Balance Sheet
Chapter 7, Slide #2
Chapter 7, Slide #3
• Indicates long-term debt-paying ability from the income statement view, i.e., if the TIE is adequate, little danger exists that the firm will not be able to meet its interest obligation
• 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)
Chapter 7, Slide #4
Recurring Earnings, Excluding InterestExpense, Tax Expense, Equity Earnings,
and Minority Earnings
Interest Expense, Including Capitalized Interest
Income Statement:Times Interest Earned
A relatively high, stable coverage of interest over the years indicates a good record.
Chapter 7, Slide #5
• 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 (cont’d)
Chapter 7, Slide #6
(Recurring Earnings + Noncash Expenses)Excluding Interest Expense, Tax Expense,
Equity Earnings, and Minority Earnings
Interest Expense, Including Capitalized Interest
Times Interest EarnedShort-Run Variation
Chapter 7, Slide #7
• Indicates firm’s ability to cover fixed charges• Extension of times interest earned ratio• Ratio trend is usually similar to trend of times-interest-earned
ratio• See Exhibit 7-3, p. 193
Recurring Earnings, Excluding InterestExpense, Tax Expense, Equity Earnings,
and Minority Earnings+ Interest Portion of Rentals
Interest Expense, Including Capitalized Interest+ Interest Portion of Rentals
Income Statement:Fixed Charge Coverage
Chapter 7, Slide #8
• Fixed charges include– Interest portion of operating lease payments
• General approximation: 1/3 of payments
– 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
Fixed Charge Coverage (cont’d)
Chapter 7, Slide #9
• Exhibit 7-4 p. 94• 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
Total Liabilities
Total Assets
Balance Sheet:Debt Ratio
Chapter 7, Slide #10
• Reserves– Matches an expense but is not a liability per se– Include in ratio for conservative application
• Deferred Income Taxes– Difference between income tax expense and income
taxes payable
Debt Ratio and Certain Liabilities
Chapter 7, Slide #11
• Minority Shareholders’ Interest– Proportion of a consolidated entity that is not owned
by the controlling parent company– Not a liability per se– 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
Debt Ratio and Certain Liabilities (cont’d)
Chapter 7, Slide #12
• Helps determine how well creditors are protected in case of insolvency
• The lower the ratio is, the better the company’s debt position.• See Exhibit 7-5, p. 197• Comparisons
– Industry competitors and averages
Total Liabilities
Shareholders' Equity
Debt/Equity Ratio
Chapter 7, Slide #13
• 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
Total Liabilities
Shareholders' Equity - Intangible Assets
Debt to Tangible Net Worth Ratio
Chapter 7, Slide #14
• 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
Other Long-Term Debt-Paying Ability Ratios
Chapter 7, Slide #15
• 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 then carrying value
• Certain assets may have earnings potential in the future
Long-Term Assets vs. Long-Term Debt
Chapter 7, Slide #16
• 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
Long-Term Leasing
Tutorials
• Please attempt Problems on pages 212-213:– P7-1– P7-2– P7-3– P7-4
Copyright 2009 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7, Slide #17