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