Long Term Solvency

1. Jones Company has long-term debt of $1,000,000, while Smith Company, Jones' competitor, has
long-term debt of $200,000. Which of the following statements best represents an analysis of the
long-term debt position of these two firms?
a. Smith Company's times interest earned should be lower than Jones.
b. Jones obviously has too much debt when compared to its competitor.
c. Jones should sell more stock and use less debt.
d. Smith has five times better long-term borrowing ability than Jones.
e. Not enough information to determine if any of the answers are correct.
ANS: E
2. Ingram Dog Kennels had the following financial statistics for 2012:

Long-term debt (average rate of interest is 8%) $400,000

Interest expense 35,000
Net income 48,000
Income tax 46,000
Operating income 107,000

What is the times interest earned for 2012?

a. 11.4 times
b. 3.3 times
c. 3.1 times
d. 3.7 times
e. None of the answers are correct.
ANS: D
3. A times interest earned ratio of 0.90 to 1 means:
a. that the firm will default on its interest payment.
b. that net income is less than the interest expense.
c. that the cash flow is less than the net income.
d. that the cash flow exceeds the net income.
e. none of the answers are correct.
ANS: B

4. Which of the following will not cause times interest earned to drop? Assume no other changes than
those listed.
a. An increase in bonds payable with no change in operating income.
b. An increase in interest rates.
c. A rise in preferred stock dividends.
d. A rise in cost of goods sold with no change in interest expense.
e. A drop in sales with no change in interest expense.
ANS: C
5. A times interest earned ratio indicates that:
a. preferred stock has no maturity date.
b. the debt will never become due.
c. the firm will be able to repay the principal when due.
d. the principal can be refinanced.
e. none of the answers are correct.
 ANS: E
6. Jordan Manufacturing reports the following capital structure:

Current liabilities $100,000

Long-term debt 400,000
Deferred income taxes 10,000
Preferred stock 80,000
Common stock 100,000
Premium on common stock 180,000
Retained earnings 170,000

What is the debt ratio?

a. 0.48
b. 0.49
c. 0.93
d. 0.96
e. None of the answers are correct.
ANS: B
7. The debt ratio indicates:
a. the ability of the firm to pay its current obligations.
b. the efficiency of the use of total assets.
c. the magnification of earnings caused by leverage.
d. a comparison of liabilities with total assets.
e. none of the answers are correct.
ANS: D

8. Joseph and John, Inc., had the following balance sheet results for 2012:

(in millions)
Current liabilities $12.6
Bonds payable 18.6
Lease obligations 2.7
Noncontrolling interest 1.4
Common stock 8.6
Retained earnings 22.9
$66.8

Compute the debt-equity ratio.

a. 112.1%
b. 87.6%
c. 67.6%
d. 46.7%
e. none of the answers are correct
ANS: A

9. Which of the following statements best compares long-term borrowing capacity ratios?
a. The debt/equity ratio is more conservative than the debt ratio.
b. The debt ratio is more conservative than the debt/equity ratio.
c. The debt/equity ratio is more conservative than the debt to tangible net worth ratio.
d. The debt to tangible net worth ratio is more conservative than the debt/equity ratio.
e. The debt ratio is more conservative than the debt to tangible net worth ratio.
 ANS: D
10. In computing debt to tangible net worth, which of the following is not subtracted in the denominator?
a. Copyrights
b. Goodwill
c. Patents
d. Investments
e. Trademarks
ANS: D
11. A fixed charge coverage:
a. is a balance sheet indication of debt carrying ability.
b. is an income statement indication of debt carrying ability.
c. is a liquidity ratio.
d. frequently includes research and development.
e. computation is standard from firm to firm.
ANS: B

12. The following financial statement data are taken from Xeron Company's 2012 annual report:

(in millions)
Current assets $12.6
Investments 9.4
Intangibles 6.8
Property, plant, and equipment 58.1
Current liabilities 6.4
Long-term debt 39.7
Stockholders' equity 40.8

Compute the debt ratio.

a. 196.9%
b. 113.0%
c. 53.0%
d. 45.7%
e. none of the answers are correct
ANS: C

13. The following financial statement data are taken from Xeron Company's 2012 annual report:

(in millions)
Current assets $12.6
Investments 9.4
Intangibles 6.8
Property, plant, and equipment 58.1
Current liabilities 6.4
Long-term debt 39.7
Stockholders' equity 40.8

Compute the debt to tangible net worth ratio.

a. 146.8%
b. 135.6%
c. 53.0%
d. 45.7%
e. none of the answers are correct
 ANS: B

14. If a firm has substantial capital or financing leases disclosed in the notes but not capitalized in the
financial statements, then:
a. the times interest earned ratio will be overstated, based upon the financial statements.
b. the fixed charge ratio will be overstated, based upon the financial statements.
c. the debt ratio will be understated.
d. the working capital will be understated.
e. None of the answers are correct.
ANS: C
15. Under the Employee Retirement Income Security Act, a company can be liable for its pension plan up
to:
a. 30 percent of its total assets
b. 30 percent of its net worth
c. 40 percent of its total assets
d. 40 percent of its net worth
e. 50 percent of its total assets
ANS: B

16. Included in the Employee Retirement Income Security Act are the following:
a. provisions requiring minimum funding of pension plans.
b. minimum rights to employees upon termination of their employment.
c. creation of the Pension Benefit Guaranty Corporation.
d. provisions requiring minimum funding of pension plans and minimum rights to employees
upon termination of their employment.
e. provisions requiring minimum funding of pension plans, minimum rights to employees
upon termination of their employment, and creation of the Pension Benefit Guaranty
Corporation.
ANS: E

17. There are a number of assumptions about future events that must be made regarding a defined benefit
plan. An assumption that does not need to be made is:
a. interest rates.
b. employee turnover.
c. mortality rates.
d. compensation.
e. how long the firm will continue.
ANS: E

18. Which of the following statements is not correct?

a. A ratio that indicates a firm's long-term, debt-paying ability from the income statement
view is the times interest earned.
b. Some of the items on the income statement that are excluded in order to compute times
interest earned are interest expense, income taxes, and unusual or infrequent items.
c. Capitalized interest should be included with interest expense when computing times
interest earned.
d. Usually, the highest times interest coverage in the most recent five-year period is used as
the primary indication of the interest coverage.
e. In the short run, a firm can often meet its interest obligations, even when the times interest
earned is less than 1.00.
 ANS: D
19. Which of these items represents a definite commitment to pay out funds in the future?
a. Bonds payable
b. Reserves for rebuilding furnaces
c. Deferred taxes
d. Noncontrolling shareholders' interests
e. Redeemable preferred stock
ANS: A

20. Which of the following statements is not true relating to a capitalized (capital) lease?
a. A capital lease is handled as if the lessee bought the asset.
b. The leased asset is in the fixed assets and the related obligation is included in liabilities.
c. On the balance sheet, the capitalized asset amount will not usually agree with the
capitalized liability amount because the liability is reduced by payments, and the asset is
reduced by depreciation taken.
d. Usually, a company depreciates capitalized leases faster than payments are made.
e. On the balance sheet, the capitalized asset amount will usually be higher than the
capitalized liability amount.
ANS: E

21. Which of the following statements is not true relating to a defined contribution pension plan?
a. A defined contribution plan defines the contributions of the company to the pension plan.
b. Once the defined contribution is paid, the company has no further obligation to the
pension plan.
c. This type of plan shifts the risk to the employee as to whether the pension plan will grow
to provide for a reasonable pension payment upon retirement.
d. There is no problem estimating the company's pension expense.
e. This type of plan presents substantial problems in estimating the pension liability.
ANS: E

22. A number of assumptions about future events must be made regarding a defined benefit plan. Which of
the following does not represent one of the assumptions?
a. Interest rates
b. Termination date for the firm
c. Employee turnover
d. Mortality rates
e. Compensation
ANS: B

TRUE/FALSE

1. When analyzing a firm's long-term, debt-paying ability, we only want to determine the firm's ability to
pay the principal.

ANS: F

2. In general, the profitability of a firm is not considered to be important in determining the short-term,
debt-paying ability of the firm.

ANS: T
 3. A good times interest earned record would be indicated by a relatively high, stable coverage for the
times interest earned coverage.

ANS: T
4. Noncontrolling shareholders' interest in earnings of subsidiaries are included in earnings for the times
interest earned coverage.

ANS: T

5. Equity earnings are excluded from earnings for the times interest earned coverage.

ANS: T

6. Capitalized interest should not be considered as part of interest in the times interest earned
computation.

ANS: F

7. To get a better indication of a firm's ability to cover interest payments in the long run, the noncash
charges for depreciation, depletion, and amortization can be added back to the times interest earned
ratio.

ANS: F

8. When a portion of operating lease payments is included in fixed charges, it is an effort to recognize the
true total interest that the firm is paying.

ANS: T

9. Under generally accepted accounting principles, an item must clearly represent a commitment to pay
out funds in the future in order to be classified as a liability.

ANS: T
10. When a firm is expensing an item faster on the tax return than on the financial statements, a deferred
tax liability is the result.

ANS: T

11. As with the debt ratio and the debt/equity ratio, from a long-term, debt-paying ability view, the lower
the debt to tangible net worth ratio, the better.

ANS: T

12. The debt to tangible net worth ratio is a more conservative ratio than the debt ratio.

ANS: T

13. A joint venture can add significant potential liabilities to the parent company that are not on the face of
the balance sheet.

ANS: T
 14. A potential significant liability is possible if the company withdraws from a multi-employer pension
plan.

ANS: T
15. A defined benefit plan shifts the risk to the employee as to whether the pension funds will grow to
provide for a reasonable pension payment upon retirement.

ANS: F
16. If an employee is in the pension plan, rights under this plan will be lost if the employee leaves the firm
prior to receiving a vested interest.

ANS: T

17. The balance sheet pension liability considers the projected benefit obligation.

ANS: F

18. Some companies achieve benefits by hundreds of millions of dollars by a pension termination.

ANS: T
19. Times interest earned indicates a firm's long-term, debt-paying ability from the balance sheet view.

ANS: F

20. Capitalization of interest results in interest being added to a fixed asset instead of expensed.

ANS: T
21. In the short run, a firm can often meet its interest obligations even when the times interest earned is
less than 1.00.

ANS: T

22. The tax expense for the financial statements often agrees with the taxes payable.

ANS: F

23. Some revenue and expense items never go on the tax return, but do go on the income statement.

ANS: T

24. Repayment of a long-term bank loan would decrease the debt ratio.

ANS: T

25. Increases of profits by cutting the cost of sales would increase the times interest earned.

ANS: T

PROBLEM

1. Laura Bella Company reports the following statement of income:

Operating Revenues $4,800

Costs and Expenses:

Cost of Sales (2,000)
Selling, Service, Administrative, and General Expense (1,500)
Income Before Interest Expense and Income Taxes $1,300
Interest Expense (180)
Income Before Income Taxes $1,120
Income Taxes (350)
Net Income $ 770

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:
a. Compute the times interest earned.
b. Compute the fixed charge coverage.

ANS:
a.

Income before income taxes $1,120

Plus interest 180
Adjusted income $1,300 (A)
Interest expense $ 180 (B)

(A) $1,300/(B) $180 = 7.22 times

b.

Income before income taxes $1,120

Plus interest 180
Adjusted income $1,300
1/3 of operating lease payments
(1/3  $180) 60
$1,360

Interest expense $180

1/3 of operating lease payments 60
$240

PTS: 1
2. The following information is computed from Fast Food Chain's annual report for 2012.

2012 2011
Current assets $ 2,731,020 $ 2,364,916
Property and equipment, net 10,960,286 8,516,833
Intangible assets, at cost less applicable
amortization 294,775 255,919
$13,986,081 $11,137,668

Current liabilities $ 3,168,123 $ 2,210,735

Deferred federal income taxes 160,000 26,000
Mortgage note payable 456,000 -
Stockholders' equity 10,201,958 8,900,933
$13,986,081 $11,137,668

Net sales $33,410,599 $25,804,285

Cost of goods sold (30,168,715) (23,159,745)
Selling and administrative expense (2,000,000) (1,500,000)
Interest expense (216,936) (39,456)
Income tax expense (400,000) (300,000)
Net income $ 624,948 $ 805,084

Note: One-third of the operating lease rental charge was $100,000 in 2012 and $50,000 in 2011.
Capitalized interest totaled $30,000 in 2012 and $20,000 in 2011.

Required:
a. Based on the above data for both years, compute:
1. times interest earned
2. fixed charge coverage
3. debt ratio
4. debt/equity ratio
5. debt to tangible net worth

b. Comment on the firm's long-term borrowing ability based on the analysis.

ANS:
a. 1.

2012 2011
Net Sales $33,410,599 $25,804,285
Less Cost of Goods Sold (30,168,715) 23,159,745)
Selling and Administrative (2,000,000) (1,500,000)
(A) $ 1,241,884 $ 1,144,540

Interest Expense $ 216,936 $ 39,456

Capitalized Interest 30,000 20,000
Total Interest (B) $ 246,936 $ 59,456
 (A)/(B) 5.03 times 19.25 times

2.

2012 2011
From Part (1) $1,241,884 $1,144,540
Interest Portion of Rentals 100,000 50,000
(A) $1,341,884 $1,194,540

From Part (1) $ 246,936 $ 59,456

Interest Portion of Rentals 100,000 50,000
(B) $ 346,936 $ 109,456

(A)/(B) 3.87 times 10.91 times

3.

4.

5.

b. In 2012, this firm had a substantial rise in debt. This included current liabilities, deferred
taxes, and a new mortgage note payable. This increased debt and the related increased
interest expense caused a decline in interest coverage and a rise in the debt, debt/equity,
and debt to tangible net worth ratios. In addition, operating lease rental charges went up,
which lowered the fixed charge coverage.

3. The following financial information is excerpted from the 2012 annual report of Retail Products, Inc.

Balance Sheet
(in thousands)
2012 2011
Current assets $ 449,195 $ 433,049
Investments 32,822 55,072
Deferred charges 4,905 12,769
Property, plant, and equipment, net 350,921 403,128
Trademarks and leaseholds 45,031 47,004
Excess of cost over fair market value of net
assets acquired 272,146 276,639
Assets held for disposal 6,062 10,247
$1,161,082 $1,237,908

Total liabilities $ 689,535 $ 721,149

Total stockholders' equity 471,547 516,759
$1,161,082 $1,237,908

Income Statement
Net sales $2,020,526 $1,841,738
Cost of goods sold (2,018,436) (1,787,126)
Selling and administrative (300,000) (250,000)
Interest expense (40,000) (30,000)
Net income (loss) $ (337,910) $ (225,388)

Required:
a. For each year compute:
1. Times interest earned
2. Debt ratio
3. Debt/equity ratio
4. Debt to tangible net worth ratio

b. Comment on the results.

c. Does a times interest earned ratio of less than 1 to 1 mean that the firm cannot pay its
interest expense?

ANS:
a. 1.

2012

Negative 7.45 Times

2011

Negative 6.51 Times

2.

2012 2011
 3.

2012 2011

4.

2012

2011

b. This firm has had a rise in the debt, debt/equity, and debt to tangible net worth ratios. The
debt to tangible net worth is especially high due to the high amount of excess of cost over
fair market value of net assets.

The times interest earned figure dropped from a negative 6.51 times in 2011 to a negative
7.45 times in 2012.

This firm's long-term borrowing ability appears to be very negative and deteriorated
further in 2012.

c. No, a times interest earned ratio of less than 1 to 1 does not mean, in the short run, that the
firm cannot meet its interest payments. Some of the expenses, such as depreciation, do not
require current funds, but they do reduce the interest coverage. Also, in the short run, the
outlay can come from sources of funds other than income.

4. Mr. Jones has asked you to advise him of the long-term debt position of Dryden Corporation. He
provides you with the ratios indicated below.

2010 2011 2012

Fixed Charge Coverage 6.3 4.5 5.0
Times Interest Earned 8.2 6.0 5.3
Debt Ratio 40% 39% 40%
Debt to Tangible Net Worth 80% 81% 84%

Required:
Give the implications and limitations of each item separately and then the collective inference one may
draw about Dryden's long-term, debt-paying ability.
 ANS:
Times interest earned has declined. This can be caused by lower income, higher debt, or a combination
of both.

Fixed charge coverage has declined. The decline for this ratio has been less than the decline in the
times interest earned. This indicates that the use of noncapitalized leases has declined.

The debt ratio is relatively stable.

The debt to tangible net worth ratio has increased slightly. This can be caused by higher debt, lower
equity, or higher intangibles.

Since the debt ratio is relatively constant, the problem does not appear to be higher debt. Rather,
higher interest rates or lower income appear to be the problem. Since the debt ratio is constant, the
most logical explanation for the rise in debt to tangible net worth is a rise in intangibles, which lowers
the denominator.

The long-term debt position has declined, but we need more information about the company and
industry in order to come to a conclusion on the long-term debt position.

5. Amsterdam Antiques reported the following comparative income figures in 2012.

(in thousands)
2010 2009
Net sales $701 $646
Other income 10 8
$711 $654
Costs and expenses:
Cost of goods sold $472 $408
Selling and general expenses 176 156
Interest 28 22
$676 $586
Income before income taxes and extraordinary items $ 35 $ 68
Income taxes (15) (30)
Income before extraordinary items $ 20 $ 38
Extraordinary itemslosses from fire 18
Net income $ 20 $ 20

Your boss, the president of Amsterdam bank, is concerned about Amsterdam's borrowing capacity. A
representative of Amsterdam Antiques 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.

ANS:
 2010 2011
Income before income taxes and extraordinary items $35 $68
Plus interest expense 28 22
(a) $63 $90

(b) Interest expense $28 $22

(a)  (b) 2.25 times 4.09 times

The ability of the firm to cover its interest has declined substantially due both to rising interest and
falling income.

The statement by the Amsterdam Antiques representative is false. The only reason that net income was
at $20,000 in 2011 was because of the extraordinary fire loss. Recurring profits dropped from $38,000
to $20,000.

6. Required:
Following is a list of paired ratios and transactions. For each transaction, indicate the effect of that
transaction on the specific ratio. Use + for increase,  for decrease, and 0 for no effect.

Transaction Ratio
a A firm is required to capitalize leases previously Debt Ratio of 0.4
presented only in notes.
b. A firm sells its own common stock. Debt/Equity Ratio of 1.12
c. A firm has an increase in selling expense with no Times Interest Earned Ratio
change in other expenses. of 6.2 to 1
d. A firm writes off a sizeable account receivable. Times Interest Earned Ratio
of 3.6 to 1
e. A firm pays cash for a valuable patent. Debt to Tangible Net Worth
Ratio of 1.3 to 1

ANS:
a +
b. 
c. 
d. 0
e. +

7. Aristocrats Art reported the following trend analysis to its bank as an attachment to a loan application.

2012 2011 2010

Fixed Charge Ratio 4.00 2.50 1.54
Times Interest Earned Ratio 4.94 3.17 2.08
Debt Ratio 0.47 0.51 0.56
Debt to Tangible Net Worth Ratio 0.91 1.06 1.36

You have been asked to evaluate the long-term borrowing capacity. You know that a rule of thumb for
this industry for the debt/ equity ratio is 1 to 1.

Required:
a. Compute the debt/equity ratio for 2012, 2011, and 2010, using the debt ratio as a guide.
b. Comment on the long-term borrowing ability of this firm.
 ANS:
a. If total liabilities are .47 of total assets, then total stockholders' equity must be .53, since
total liabilities plus total stockholders' equity = total assets.

b. This firm shows evidence of an improved, long-term borrowing capacity position. The
times interest earned ratio and the fixed charge ratio has improved, as has the debt ratio,
debt to tangible net worth ratio, and debt/equity ratio. The debt/equity ratio is now below
the industry average.

8. You have been asked to evaluate the long-term borrowing position of Client, Inc. However, you were
given only the following limited information.

Bonds payable, 12% $1,000,000

Stockholders' equity 1,800,000
Current assets 1,870,000
Tangible assets, net 1,600,000
Intangible assets 40,000
Investments 120,000
Other assets 90,000
Sales 4,000,000
Operating expenses 3,620,000

Required:
Assuming that this is the only information you will receive, estimate the following ratios:
a. Times interest earned ratio
b. Debt ratio
c. Debt/equity ratio
d. Debt to tangible net worth ratio

ANS:
Computations for figures needed in the ratios follow.

Total assets:
Current assets $1,870,000
Tangible assets 1,600,000
Intangible assets 40,000
Investments 120,000
Other assets 90,000
Total assets $3,720,000

Liabilities:
Total assets $3,720,000
Less stockholders' equity 1,800,000
Total liabilities $1,920,000
 Interest:
$1,000,000  0.12 = $120,000

a.

times

b.

c.

d.

9. Required:
Indicate the effect of each of the following transactions on the ratios listed. Use + to indicate an
increase,  to indicate a decrease, and 0 to indicate no effect. Assume an initial times interest earned
ratio of 3 to 1, debt ratio of 0.5 to 1, debt/equity ratio of 1.0 to 1, and total debt to tangible net worth
ratio of 1.1 to 1.

Times Debt Total Debt

Interest Debt Equity Tangible Net
Transaction Earned Ratio Ratio Ratio Worth Ratio
a. Collection of accounts receivable. ____ ____ ____ ____
b. Firm has decreasing profits due to ____ ____ ____ ____
rising cost of sales.
c. Firm appropriates a substantial ____ ____ ____ ____
amount for expansion.
d. Conversion of preferred stock to ____ ____ ____ ____
common.
e. Repayment of a short-term bank loan ____ ____ ____ ____
(ignore interest).
f. Payment for a valuable trademark. ____ ____ ____ ____
g. The stock is split two for one. ____ ____ ____ ____
h. Purchase of equipment financed by a ____ ____ ____ ____
long-term note (consider interest).
i. Conversion of bonds to stock. ____ ____ ____ ____
j. Declaration and payment of dividend. ____ ____ ____ ____
 k. The firm experiences a rise in the rate ____ ____ ____ ____
charged on its line of credit.

ANS:
Times Debt Total Debt
Interest Debt Equity Tangible Net
Transaction Earned Ratio Ratio Ratio Worth Ratio
a. Collection of accounts receivable. 0 0 0 0
b. Firm has decreasing profits due to    
rising cost of sales.
c. Firm appropriates a substantial 0 0 0 0
amount for expansion.
d. Conversion of preferred stock to 0 0 0 0
common.
e. Repayment of a short-term bank loan 0   
(ignore interest).
f. Payment for a valuable trademark. 0 0 0 +
g. The stock is split two for one. 0 0 0 0
h. Purchase of equipment financed by a  + + +
long-term note (consider interest).
i. Conversion of bonds to stock. +   
j. Declaration and payment of dividend. 0 + + +
k. The firm experiences a rise in the rate  + + +
charged on its line of credit.

PTS: 1 DIF: Difficulty: Moderate NAT: BUSPROG: Analytic

STA: AICPA: FN: Measurement | ACBSP: Financial Statement Analysis | IMA: Financial Statement
Analysis
TOP: Income Statement Consideration When Determining Long-Term Debt-Paying Ability | Balance
Sheet Consideration When Determining Long-Term Debt-Paying Ability
KEY: Bloom's: Analysis NOT: Time: 20 min.

MATCHING

Listed below are several ratios.

Required:
Match the ratio that goes with each formula.

a. times interest earned

b. fixed charge coverage
c. debt ratio
d. debt/equity ratio
e. debt to tangible net worth

1.

2.
3.

4.

5.

1. ANS: E
2. ANS: C
3. ANS: A
4. ANS: B
5. ANS: D