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MULTIPLE CHOICE
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 2008:
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
7-1
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
7-2
8. Joseph and John, Inc., had the following balance sheet results for 2008:
(in millions)
Current liabilities $12.6
Bonds payable 18.6
Lease obligations 2.7
Minority interest 1.4
Common stock 8.6
Retained earnings 22.9
$66.8
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
7-3
12. The following financial statement data are taken from Xeron Company's 2008 annual report:
(in millions)
Current assets $12.6
Investments 9.4
Intangibles 6.8
Tangible assets (net) 58.1
Current liabilities 6.4
Long-term debt 39.7
Stockholders' equity 40.8
13. The following financial statement data are taken from Xeron Company's 2008 annual report:
(in millions)
Current assets $12.6
Investments 9.4
Intangibles 6.8
Tangible assets (net) 58.1
Current liabilities 6.4
Long-term debt 39.7
Stockholders' equity 40.8
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
7-4
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. What significant improvement in the financial reporting of pensions have pension accounting rules
provided?
a. determination of the expense for the income statement
b. limited balance sheet recognition of pension liabilities
c. improved disclosure
d. determination of the expense for the income statement and limited balance sheet
recognition of pension liabilities
e. determination of the expense for the income statement, limited balance sheet recognition
of pension liabilities, and improved disclosure
ANS: E
18. 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
7-5
19. 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
20. 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. minority shareholders' interests
e. redeemable preferred stock
ANS: A
21. 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
22. 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
23. 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
7-6
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. Minority 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
7-7
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
7-8
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
PROBLEMS
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.
7-9
ANS:
a.
b.
7-10
2. The following information is computed from Fast Food Chains annual report for 2008.
2008 2007
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
Note: One-third of the operating lease rental charge was $100,000 in 2008 and $50,000 in 2007.
Capitalized interest totaled $30,000 in 2008 and $20,000 in 2007.
Required:
a. Based on the above data for both years, compute:
1. times interest earned
2. fixed charge
3. debt ratio
4. debt/equity ratio
5. debt to tangible net worth
7-11
ANS:
a.
1.
2008 2007
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
2008 2007
From Part (1) $1,241,884 $1,144,540
Interest Portion of Rentals 100,000 50,000
(A) $1,341,884 $1,194,540
$3,784,123 $2,236,735
$13,986,081 $11,137,668
27.1% 20.1%
7-12
4. Debt/Equity Ratio = Total Liabilities
Stockholders' Equity
$3,784,123 $2,236,735
$10,201,958 8,900,933
37.1% 25.1%
b. In 2008, 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 2008 annual report of Retail Products, Inc.
Balance Sheet
(in thousands)
2008 2007
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
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)
7-13
Required:
For each year compute:
a. 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.
Recurring Earnings Before
Interest, Tax, Minority Income
1. Times Interest Earned = and Equity Earnings
Interest Expense, Including
Capitalized Interest
2008
$2,020,526 - $2,018,436 - $300,000
$40,000
2007
$1,841,738 - $1,787,126 - $250,000
$30,000
2008 2007
$689,535 $721,149
$1,161,082 $1,237,908
59.4% 58.3%
2008 2007
$689,535 $721,149
$471,547 $516,759
146.2% 139.6%
7-14
4. Debt to Tangible = Total Liabilities
Net worth Ratio Total Stockholders' Equity - Intangible Assets
2008
$689,535 = 446.7%
$471,547 - $45,031 - $272,146
2007
$721,149 = 373.4%
$516,759 - $47,004 - $276,639
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 2007 to a negative
7.45 times in 2008.
This firm's long-term borrowing ability appears to be very negative and deteriorated further
in 2008.
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.
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.
7-15
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 to tangible net worth ratio has increased slightly. This can be caused by higher debt, lower
equity, or higher intangibles.
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.
(in thousands)
2008 2007
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 itemslosses 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.
7-16
ANS:
2008 2007
Income before income taxes and extraordinary items $ 35 $ 68
Plus interest expense 28 22
(a) $ 63 $ 90
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 2007 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 Times Interest Earned Ratio of 6.2 to 1
no change in other expenses.
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. +
7-17
7. Aristocrats Art reported the following trend analysis to its bank as an attachment to a loan application.
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 2008, 2007, and 2006, 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.
7-18
8. You have been asked to evaluate the long-term borrowing position of Client, Inc. However, you were
given only the following limited information.
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:
Liabilities:
Interest:
7-19
b. Debt Ratio = Total Liabilities
Total Assets
= $1,920,000 = 51.6%
$3,720,000
= $1,920,000 = 106.7%
$1,800,000
= $1,920,000 = 109.1%
$1,800,000 - $40,000
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.
7-20
ANS:
7-21
10. Listed below are several ratios.
Required:
Match the letter that goes with each formula.
ANS:
1. e
2. c
3. a
4. b
5. d
7-22