Test Bank - Chapter 7 PDF

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CHAPTER 7—LONG-TERM DEBT-PAYING ABILITY MULTIPLE CHOICE 1. Jones Company has long-term debt of $1,000,000, while Smith Company, Jones' competitor, has longterm 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: Long-term debt (average rate of interest is 8%) Interest expense Net income Income tax Operating income

$400,000 35,000 48,000 46,000 107,000

What is the times interest earned for 2008? a. 11.4 times b. 3.3 times c. 3.1 times d. 3.7 times e. none of the answers are correct ANS: D 3. A times interest earned ratio of 0.90 to 1 means: a. that the firm will default on its interest payment b. that net income is less than the interest expense c. that the cash flow is less than the net income d. that the cash flow exceeds the net income e. none of the answers are correct ANS: B 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

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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 6. Jordan Manufacturing reports the following capital structure: Current liabilities Long-term debt Deferred income taxes Preferred stock Common stock Premium on common stock Retained earnings

$100,000 400,000 10,000 80,000 100,000 180,000 170,000

What is the debt ratio? a. 0.48 b. 0.49 c. 0.93 d. 0.96 e. none of the answers are correct ANS: B 7. The debt ratio indicates: a. the ability of the firm to pay its current obligations b. the efficiency of the use of total assets c. the magnification of earnings caused by leverage d. a comparison of liabilities with total assets e. none of the answers are correct ANS: D

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8. Joseph and John, Inc., had the following balance sheet results for 2008: (in millions) Current liabilities Bonds payable Lease obligations Minority interest Common stock Retained earnings

$12.6 18.6 2.7 1.4 8.6 22.9 $66.8

Compute the debt-equity ratio. a. 112.1% b. 87.6% c. 67.6% d. 46.7% e. none of the answers are correct ANS: A 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 11. A fixed charge coverage: a. is a balance sheet indication of debt carrying ability b. is an income statement indication of debt carrying ability c. is a liquidity ratio d. frequently includes research and development e. computation is standard from firm to firm ANS: B

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12. The following financial statement data are taken from Xeron Company's 2008 annual report: (in millions) Current assets Investments Intangibles Tangible assets (net) Current liabilities Long-term debt Stockholders' equity

$12.6 9.4 6.8 58.1 6.4 39.7 40.8

Compute the debt ratio. a. 196.9% b. 113.0% c. 53.0% d. 45.7% e. none of the answers are correct ANS: C 13. The following financial statement data are taken from Xeron Company's 2008 annual report: (in millions) Current assets Investments Intangibles Tangible assets (net) Current liabilities Long-term debt Stockholders' equity

$12.6 9.4 6.8 58.1 6.4 39.7 40.8

Compute the debt to tangible net worth ratio. a. 146.8% b. 135.6% c. 53.0% d. 45.7% e. none of the answers are correct ANS: B 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

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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

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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

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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

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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

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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 1. Laura Bella Company reports the following statement of income: Operating Revenues

$4,800

Costs and Expenses: Cost of Sales Selling, Service, Administrative, and General Expense Income Before Interest Expense and Income Taxes Interest Expense Income Before Income Taxes Income Taxes Net Income

(2,000) (1,500) $1,300 (180) $1,120 (350) $ 770

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.

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ANS: a. Recurring Earnings Before Interest Expense, Tax, Minority Income and Equity Earnings Interest Expense, Including Capitalized Interest

Times Interest Earned =

Income before income taxes Plus interest Adjusted income Interest expense

$1,120 180 $1,300 (A) $ 180 (B)

(A) $1,300/(B) $180 = 7.22 times b.

Fixed Charge Coverage =

Recurring Earnings Before Interest Expense, Tax, Minority Income and Equity Earnings + Interest Portion of Rentals Interest Expense, Including Capitalized Interest + Interest Portion of Rentals

Income before income taxes Plus interest Adjusted income 1/3 of operating lease payments (1/3 $180)

Interest expense 1/3 of operating lease payments

Fixed charge coverage =

$1,360 $240

$1,120 180 $1,300 60 $1,360

$180 60 $240

= 5.67 times

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2. The following information is computed from Fast Food Chain’s annual report for 2008. 2008 Current assets Property and equipment, net Intangible assets, at cost less applicable amortization

2007

$ 2,731,020 $ 2,364,916 10,960,286 8,516,833 294,775 255,919 $13,986,081 $11,137,668

Current liabilities Deferred federal income taxes Mortgage note payable Stockholders' equity

$ 3,168,123 $ 2,210,735 160,000 26,000 456,000 — 10,201,958 8,900,933 $13,986,081 $11,137,668

Net sales Cost of goods sold Selling and administrative expense Interest expense Income tax expense Net income

$33,410,599 $25,804,285 (30,168,715) (23,159,745) (2,000,000) (1,500,000) (216,936) (39,456) (400,000) (300,000) $ 624,948 $ 805,084

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 b. Comment on the firm's long-term borrowing ability based on the analysis.

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ANS: a. 1. Recurring Earnings Before Interest Expense, Tax, Minority Income and Equity Earnings Interest Expense, Including Capitalized Interest

Times Interest Earned =

2008

2007

Net Sales Less Cost of Goods Sold Selling and Administrative (A)

$ 33,410,599 $25,804,285 (30,168,715) 23,159,745) (2,000,000) (1,500,000) $ 1,241,884 $ 1,144,540

Interest Expense Capitalized Interest Total Interest (B)

$ 216,936 $ 39,456 30,000 20,000 $ 246,936 $ 59,456

(A)/(B)

5.03 times

2. Fixed Charge Interest =

Recurring Earnings Before Interest Expense, Tax, Minority Earnings, Equity Earnings, Plus Interest Portion of Rentals Interest Expense, Including Capitalized Interest, Plus Interest Portion of Rentals 2008

From Part (1) Interest Portion of Rentals (A)

$1,241,884 100,000 $1,341,884

From Part (1) Interest Portion of Rentals (B)

$ 246,936 100,000 $ 346,936

2007 $1,144,540 50,000 $1,194,540 $ 59,456 50,000 $ 109,456

3.87 times 10.91 times

(A)/(B) 3. Debt Ratio =

19.25 times

Total Liabilities Total Assets $3,784,123 $13,986,081 27.1%

$2,236,735 $11,137,668 20.1%

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4. Debt/Equity Ratio =

Total Liabilities Stockholders' Equity $3,784,123 $10,201,958

$2,236,735 8,900,933

37.1% 5. Debt to Tangible Net Worth =

$3,784,123 $10,201,958 - $294,775

25.1%

Total Liabilities Stockholders' Equity - Intangibles = 38.2%

$2,236,735 $8,900,933 - $255,919

= 25.9%

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 Investments Deferred charges Property, plant, and equipment, net Trademarks and leaseholds Excess of cost over fair market value of net assets acquired Assets held for disposal

$ 449,195 $ 433,049 32,822 55,072 4,905 12,769 350,921 403,128 45,031 47,004 272,146

276,639

6,062 10,247 $ 1,161,082 $1,237,908

Total liabilities Total stockholders' equity

$ 689,535 $ 721,149 471,547 516,759 $ 1,161,082 $1,237,908

Income Statement Net sales Cost of goods sold Selling and administrative Interest expense Net income (loss)

$ 2,020,526 $1,841,738 (2,018,436) (1,787,126) (300,000) (250,000) (40,000) (30,000) $ (337,910) $ (225,388)

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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 and Equity Earnings Interest Expense, Including Capitalized Interest

1. Times Interest Earned =

2008 $2,020,526 - $2,018,436 - $300,000 $40,000 Negative 7.45 Times 2007 $1,841,738 - $1,787,126 - $250,000 $30,000 Negative 6.51 Times

2. Debt Ratio =

2008

Total Liabilities Total Assets 2007

$689,535 $1,161,082

$721,149 $1,237,908

59.4%

3.

58.3%

Debt/Equity Ratio =

2008

Total Liabilities Total Stockholders' Equity

2007 $689,535 $471,547

146.2%

$721,149 $516,759 139.6%

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4.

Debt to Tangible Net worth Ratio

=

Total Liabilities 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. ...