Chapter

Long-Term
Debt-Paying Ability

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• Two approaches to viewing a firm’s long-term
debt-paying ability
• One approach views the firm’s ability to carry the
debt as indicated by the income statement, and
the other considers the firm’s ability to carry the
debt as indicated by the balance sheet.
• The firms ability to carry debt, as indicated by
the income statement, can be viewed by
considering the times interest earned and the
fixed charge coverage.
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1. Times Interest Earned
Indicates a firm’s long-term debt-paying ability from the income
statement view.
If the times interest earned is adequate, little danger exists that
the firm will not be able to meet its interest obligation.
If the firm has good coverage of interest obligation, it should
also be able to refinance the principle when it comes due.
In effect, the funds will probably never be required to pay off
the principle if the company has a good record of covering
the interest expense.
Companies that maintain a good record ,of interest coverage,
can finance a relatively high proportion of debt in relation to
shareholder’s equity and, at the same time, obtain funds at
favorable rates(Less than market).
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Times Interest Earned—Continued
In computing of times interest earned consider only
recurring income (income expected to occur subsequent
periods).
Thus the following nonrecurring items should be
excluded:
Discontinued Operations and Extraordinary Items

Recurring Earnings, Excluding Interest

Expense, Tax Expense, Equity Earnings,
and Noncontrolling Interest
Times Interest Earned =
Interest Expense, Including Capitalized
Interest
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 In addition to these nonrecurring items, other items that
should be excluded for times interest earned computation
include:
1. Interest expense: added back to net income because the
interest coverage would be understated by one if interest
expense were deducted from computing times interest
earned.
2. Income tax expenses: added back to net income because
income taxes are computed after deducting interest
expense, so they do not affect the safety of interest
payments.(‫)قيمة الضرائب تخصم بعد تحصيل الفوائد‬

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 3. Equity in earnings (or losses) of nonconsolidated
subsidiaries: these are excluded because they are
income from other companies, not available to cover
interest payments of this company, to avoid inconsistency
between numerator and denominator of the equation.
4. Net income — Noncontrolling interest: Excluded because
it results from consolidating a firm in which a company
has control but less than 100% ownership. All of the
interest expense of the firm consolidated is included in the
consolidated income statement.
Therefore, all of the income of the firm consolidated
should be considered in the coverage.

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• In the denominator: Include interest capitalized
• Capitalization of interest results in interest added to fixed asset
instead of expensed.‫فوائد القرض تؤجل لحين إتمام بناء المنشأة‬
• The interest capitalized should be included with the total interest
expense in the denominator of the times interest earned ratio
because it is a part of interest payment.
• To evaluate the adequacy of interest coverage, the times of interest
earned should be computed for a period of 3 to 5 years and
compared to competitors and industry average. This computation
shows the stability of the interest coverage.
• Interest Capitalization. Capitalization is the addition of unpaid interest to the
principal balance of your loan. The principal balance of a loan increases when
payments are postponed during periods of deferment‫ تأجيل‬or forbearance‫ سماح‬and
unpaid interest is capitalized.

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 2. Fixed Charge Coverage
• Indicates a firm’s ability to cover fixed charges
• This ratio is an extension of the time’s interest earned ratio.
• Fixed charges include interest expense including
capitalized interest and Interest portion of operating lease
payments
Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Noncontrolling Interest + Interest
Portion of Rentals
Fixed Charge Coverage =
Interest Expense, Including Capitalized
Interest + Interest Portion of Rentals
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 Fixed Charge Coverage (continued)
• A portion of operating lease payments is an item frequently
included in addition to interest expense.
• An operating lease for a relatively long term is a type of
financing, so part of the lease payment is really interest.
• 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 pays.
• The interest portion of operating lease is added to the adjusted
earnings because it was previously deducted on the income
statement as rental charges(Delete the Effect of Interest
Portion).
• General approximation is to include 1/3 of operating lease
rental charge payments
• (P. 7-4 , P. 302)
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PROBLEM 7-4

• a. Times Interest Earned =

• Income before income taxes and extraordinary
charges $36
• Plus interest 16
• (1) Adjusted income 52
• (2) Interest expense $ 16
• Times Interest Earned: (1) divided by (2) = 3.25
times per year

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b.
Adjusted income from part (a) $ 52
• 1/3 of operating lease payments (1/3 x $150) 50
• (1) Adjusted income, including rentals $ 102

• Interest expense $ 16
• 1/3 of operating lease payments 50
• (2) Adjusted interest expense $ 66
• Fixed charge coverage: (1) ÷ (2) = 1.55 times per year

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Balance sheet consideration
• The firm’ s ability to carry debt, as indicated by
the balance sheet, can be viewed by considering
the debt ratio and the debt/equity ratio.

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1. Debt Ratio
• Indicates the firm’s long-term debt-paying ability.
• Debt Ratio = Total Liabilities ÷ Total Assets
• Also, indicates the percentage of assets financed
by creditors, and it helps to determine how well
creditors are protected in case of insolvency.
• From the perspective of long-term debt-paying
ability, the lower this ratio is, the better the
company’s debt position.
• The debt ratio should be compared with
competitors and industry averages
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2. Debt/Equity Ratio
• Debt/Equity Ratio = Total Liabilities ÷
Shareholders’ Equity.
• The ratio ddetermines the entity’s long-term debt-
paying ability, and helps determine how well
creditors are protected in case of insolvency.
• From the perspective of long-term debt-paying
ability, the lower this ratio is, the better the
company’s debt position.
• This ratio should be compared with competitors
and industry averages.
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3. Debt to Tangible Net Worth Ratio
• Determines the entity’s long-term debt payment ability,
and 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, because the do not provide
resources to pay creditors- a very conservative position.
• As with the debt ratio and the debt/equity ratio, from the
perspective of long-term debt-paying ability.
• It is better to have a lower ratio.
Total Liabilitites
Debt to Tangible Net Worth Ratio =
Shareholders' Equity  Intangible Assets

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PROBLEM 7-6. p. 304
a. Debt Ratio =
Total Liabilities ÷ total Assets = $174,979 ÷ $424,201 = 41.2%
b. Debt/Equity Ratio = Total Liabilities ÷ Stockholders ’ Equity
$174,979 ÷ 249,222 = 70.2%
c. Ratio of Total Debt to Tangible Net Worth =
$174,979 ÷ (249,222 – $2,324) = 70.9%
d. Kaufman Company has financed over 41% of its assets by
the use of funds from outside creditors. The Debt/Equity
Ratio and the Debt to Tangible Net Worth Ratio are over
70%. Whether these ratios are reasonable depends upon
the stability of earnings.
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 PROBLEM 7-7. p 305

a. 1. Times Interest Earned

(Allen) = $95,000 ÷ $10,000 = 9.5 times
(Barker) = $170,000 ÷ $32,000 = 5.3 times
2. Debt Ratio = Total Liabilities ÷ Total Assets
Allen = $160,000 ÷ $356,000 = 44.9%
Barker = $575,000 ÷ $985,000 = 58.4%
3. Debt Equity = Total Liabilities ÷ Shareholders’ Equity
Allen = $160,000 ÷ $ 196,000 = 81.6%
Barker = $575,000 ÷ $410,000 = 140.2%

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4. Debt to Tangible Net Worth = Total Liabilities
÷ (Shareholders’ Equity – Intangibles)
Allen = $160,000 ÷ ($196,000 – $11,000) = 86.5%
Barker = $575,000 ÷ ($410,000 – $20,000) = 147.4%
• b. No, Barker Company has a times interest earned of 5.3
times while the industry average is 7.2 times. This indicates
that Barker Company has less than average coverage of its
interest. Also, Barker Company has a much higher than
average debt/equity ratio, and debt to tangible net worth ratio.
• c. Allen Company has a better long-term debt position
because it has a better times interest earned, debt ratio,
debt/equity ratio, and debt to tangible net worth
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PROBLEM 7-8

a. Times Interest Earned = (Recurring Earnings,

Excluding Interest Expense, Tax Expense,
Equity Earnings, and Minority Earnings) ÷
Interest Expense, Including Capitalized Interest
Income before income taxes $ 675
Plus interest 60
= Adjusted income $ 735
Interest expense $ 60
Times interest earned = $735 $60 = = 12.25 times
per year
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 Problem 7-8 (continued)
b. 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
Adjusted income from part (a) $ 735
+ 1/3 of operating lease payments (1/3 x $150) 50
= Adjusted income, including rentals $ 785
Interest expense $ 60
+ 1/3 of operating lease payments 50
= $ 110
• Fixed Charge Coverage = $785 ÷ $110 = = 7.14 times per year
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PROBLEM 7-9

a. 4 The times interest earned ratio indicates a firm’s

long-term debt-paying ability from the income
statement view.
b. 5 Preferred stock is owned by stockholders.
c. 5 The bonds payable liability will be shown on the
balance sheet.
d. 5 The denominator of the debt ratio is total assets.
Therefore, none of these assets are subtracted.
e. 5 The current ratio is considered to be a liquidity
ratio.

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PROBLEM 7-9 (continued)

f. 4 The debt/equity ratio represents a balance

sheet view of debt.
g. 5 There is not adequate information to form
an opinion on the long-term debt position.
h. 2 With a times interest earned ratio of .20 to
1, net income is less than the interest expense.
i. 5 Intangible assets are subtracted in the
denominator. Land and bonds payable are not
intangible assets.

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PROBLEM 7-9 (continued
j. 2 The ratio fixed charge coverage is an income
statement indication of debt paying ability.
k. 1 The Employee Retirement Income Security Act
calls for a company to be liable for its pension plan up
to 30 percent of its net worth.
l. 1 Capitalized interest should be included with
interest expense when computing times interest
earned.
m. 3 Minority shareholders’ interest does not represent
a definite commitment to pay out funds in the future

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