HUANGHUAI UNIVERSITY BANGOR UNIVERSITY Lecture 6 LongTerm DebtPaying

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 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 Chapter 7, Slide #6

Income Statement: Fixed Charge Coverage • 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 • 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 • 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 • 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