HUANGHUAI UNIVERSITY
&
BANGOR UNIVERSITY
Lecture 6
Long-Term
Debt-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
Times Interest Earned (cont’d)
• 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
Chapter 7, Slide #3
Income Statement:
Times Interest Earned
Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Minority Earnings
Interest Expense, Including Capitalized Interest
A relatively high, stable coverage of interest over the
years indicates a good record.
Chapter 7, Slide #4
Times Interest Earned (cont’d)
• 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
Chapter 7, Slide #5
Times Interest Earned
Short-Run Variation
(Recurring Earnings + Noncash Expenses)
Excluding Interest Expense, Tax Expense,
Equity Earnings, and Minority Earnings
Interest Expense, Including Capitalized Interest
Chapter 7, Slide #6
Income Statement:
Fixed Charge Coverage
Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Minority Earnings
+ Interest Portion of Rentals
Interest Expense, Including Capitalized Interest
+ Interest Portion of Rentals
• Indicates firm’s ability to cover fixed charges
• Extension of times interest earned ratio
• Ratio trend is usually similar to trend of timesinterest-earned ratio
• See Exhibit 7-3, p. 193
Chapter 7, Slide #7
Fixed Charge Coverage (cont’d)
• 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
Chapter 7, Slide #8
Balance Sheet:
Debt Ratio
Total Liabilities
Total Assets
• 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
Chapter 7, Slide #9
Debt Ratio and Certain Liabilities
• 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
Chapter 7, Slide #10
Debt Ratio and Certain Liabilities (cont’d)
• 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
Chapter 7, Slide #11
Debt/Equity Ratio
Total Liabilities
Shareholders' Equity
• 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
Chapter 7, Slide #12
Debt to Tangible Net Worth Ratio
Total Liabilities
Shareholders' Equity - Intangible Assets
• 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
Chapter 7, Slide #13
Other Long-Term Debt-Paying Ability Ratios
• 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
Chapter 7, Slide #14
Long-Term Assets vs. 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
Chapter 7, Slide #15
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
Chapter 7, Slide #16
Tutorials
• Please attempt Problems on pages 212-213:
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–
–
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P7-1
P7-2
P7-3
P7-4
Copyright 2009 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 7, Slide #17