Professional Documents
Culture Documents
Topic 7
Topic 7
Total Liabilities
Debt/Equity Ratio =
Shareholders' Equity
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
Total Liabilitites
Debt to Tangible Net Worth Ratio =
Shareholders' Equity Intangible Assets
Other Long-Term Debt-Paying
Ability Ratios
• Current debt/net worth ratio
– Indicates a relationship between current liabilities and
funds contributed by shareholders
– The higher the proportion of funds provided by current
liabilities, the greater the risk
• Total capitalization ratio
– Compares long-term debt to total capitalization
– Total capitalization consist of long-term debt,
preferred stock, and common stockholders’ equity
– The lower the ratio, the lower the risk
Other Long-Term Debt-Paying
Ability Ratios—Continued
• Fixed asset/equity ratio
– The extent to which shareholders have provided
funds in relation to fixed assets
– Subtracting intangibles from shareholders’ equity will
result in more conservative ratio
– The higher the fixed assets in relation to equity, the
greater the risk
Long-Term Assets versus 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 then carrying value
• Certain assets may have earnings potential in
the future
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
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 a special federal agency, the Pension Benefit
Guaranty Corporation (PBGC)
Defined Contribution Plan
• Defines the contributions of the company to the
pension plan
• Employer bears no risk for future growth of plan
• No complexity in estimating company’s pension
liability or pension expense
• 401(k) 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; note any balance sheet items
Defined Benefit Plan
• Defines the benefits to be received by the
participants in the plan
• Employer must fund sufficiently to achieve
benefit
• Note actuarial assumptions inherent in the plan
– Interest (discount) rates
– Employee turnover
– Mortality rates
– Compensation
– Pension benefits
Defined Benefit Plan—Continued
• Trend analysis
– Compare three years of pension expense in
relationship to operating revenue and income before
income taxes
• Compare benefit obligations to plan assets
– Underfunding represents a potential liability
– Overfunding represents an opportunity to reduce
future pension expense and/or reduce related costs
• Note the net balance sheet liability (asset)
recognized
Postretirement Benefits
Other 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 plans for
pension
Joint Ventures
• An association of two or more businesses
established for a special purpose
• Consolidation
– Done by the parent firm if it has control using a pro-
rata share
• Carried in an investment account
• Analysis
– Review footnote that relates to the joint venture
– Off-balance sheet commitments represent potential
liabilities
Contingencies
• An existing condition involving uncertainty as to
possible gain or loss to an enterprise
– Will be resolved when one or more future events
occur or fail to occur
• Loss contingencies that are not accrued are
included in the footnotes
• Gain contingencies are not accrued
– Review contingency note for possible liabilities and
gain contingencies not disclosed on the balance
sheet
Financial Instruments with
Off-Balance-Sheet Risk
• Disclosure is required of
– The face or contract amount
– Nature and terms of the instrument
– Amount of the potential loss
– Entity’s collateral policy and description of the
collateral it currently holds
• Accounting loss occurs when
– The co-party fails to perform the terms of contract
– Changes in market make a instrument less valuable
or more troublesome
Financial Instruments
with Concentrations of Credit Risk
• Disclosure is required of the extent of risk from
exposures to individuals or groups of
counterparties in the same industry or region
• Small companies are particularly susceptible to
concentration risk
Disclosures About
Fair Value of Financial Instruments
• Disclosure of financial instrument’s fair value is
required
– On-balance sheet assets and liabilities
– Off-balance sheet assets and liabilities
• If estimation of fair value is not practicable
– Descriptive information pertinent to estimating fair
value is provided