Long-Term Debt-Paying Ability COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 7

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #2 Times Interest Earned

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #3 Times Interest Earned (cont’d) Indicates long-term debt-paying ability 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 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 Slightly different analysis –Interest coverage on long-term debt –Use only interest on long-term debt Not practical for external analysis

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #5 Times Interest Earned Short-Run Variation Short-run coverage –Add back noncash expenses to recurring income (Depreciation/Gains/Losses) –Less conservative

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #6 Fixed Charge Coverage Ratio trend is usually similar to trend of times- interest-earned ratio

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #7 Fixed Charge Coverage (cont’d) Fixed charges include –Interest portion of operating lease payments General approximation: 1/3 of payments SEC requires specific calculation using lease terms –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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #8 Debt Ratio Indicates the percentage of assets financed by creditors Comparisons –Industry competitors and averages Variations in application –Exclude short-term liabilities if NOT part of long-term source of funds –Liabilities that do not necessarily represent a commitment to pay out funds in the future

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #9 Debt Ratio and Certain Liabilities Reserves –Matches an expense but is not a liability per se –Infrequently used in U.S. GAAP statements –Include in ratio for conservative application Deferred Income Taxes –Difference between income tax expense and income taxes payable –Commonplace in U.S. GAAP statements –Recognized as a liability by GAAP; include in ratio

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #11 Debt/Equity Ratio Helps determine how well creditors are protected in case of insolvency Comparisons –Industry competitors and averages

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #12 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 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 Fixed asset/equity ratio –The extent to which shareholders have provided funds in relation to fixed assets

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #14 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #15 Pension Plans Employee Retirement Income Security Act (ERISA) –Includes provisions requiring Minimum funding of plans Minimum rights to employees upon termination of their employment Pension Benefit Guaranty Corporation –2 main types

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #16 1) Defined Contribution Plan Contributions to the plan are specified Employer bears no risk for future growth of plan No complex expense or liability issues 401K 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 Most Companies are going with this type of plan

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #17 2) Defined Benefit Plan Defines the benefits to be received Employer must fund sufficiently to achieve benefit Note actuarial assumptions inherent in the plan –Interest (discount) rates –Employee turnover –Mortality rates –Compensation –Pension benefits

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #18 2) Defined Benefit Plan (cont’d) Compare three years of –Pension expense in relationship to operating revenue and income before income taxes Compare benefit obligations to plan assets –Underfunded: a potential liability –Overfunded: potential opportunities to reduce future pension expense and/or reduce related costs

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #19 2) Defined Benefit Plan (cont’d) Consider employer’s pension-related assumptions and the effect that changes in the assumptions will have on recognized and off- balance-sheet pension accounts –Interest (discount) rate –Rate of compensation increase –Expected return on plan assets changes

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #20 Joint Ventures An association of two or more businesses established for a special purpose Consolidation –Parent firm has control Carry as an investment –Parent firm has significant influence Analysis –Review footnote for commitments relating to the joint venture –Off-balance sheet commitments represent potential liabilities

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #21 Contingencies Loss contingencies that are not accrued are footnoted if it is reasonably possible that an asset has been impaired or a liability has been incurred –Review contingency note for possible liabilities not disclosed on the balance sheet Gain contingencies are not accrued –Examples: Viox lawsuits

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #22 Financial Instruments with Off-Balance-Sheet Risk Disclosure is required of –Contract face amount –Nature and terms of the instrument –Amount of the potential loss –Entity’s collateral policy and description of the collateral Risk: Potential loss if –The co-party fails to perform –Changes in market make instrument less valuable

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #23 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #24 Disclosures About Fair Value of Financial Instruments Disclosure of financial instrument 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