1. HUANGHUAI UNIVERSITY & BANGOR UNIVERSITY Lecture 6 Long-Term Debt-Paying Ability DR. AZIZ JAAFAR Chapter 6, Slide #1

2. 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

3. 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)

4. Chapter 7, Slide #4 Income Statement: Times Interest Earned A relatively high, stable coverage of interest over the years indicates a good record.

5. 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)

6. Chapter 7, Slide #6 Times Interest Earned Short-Run Variation

7. 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 Income Statement: Fixed Charge Coverage

8. 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)

9. 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 Balance Sheet: Debt Ratio

10. 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

11. 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)

12. 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 Debt/Equity Ratio

13. 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 Debt to Tangible Net Worth Ratio

14. 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

15. 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

16. 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

17. 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