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Questions and Answers
What is the primary significance of long-term debt in a company's financial structure?
What is the primary significance of long-term debt in a company's financial structure?
Which financial ratio is used to assess a company's ability to meet long-term obligations?
Which financial ratio is used to assess a company's ability to meet long-term obligations?
What characterizes the repayment schedule of long-term debt?
What characterizes the repayment schedule of long-term debt?
What is a common feature of interest payments on long-term debt?
What is a common feature of interest payments on long-term debt?
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Which ratio assesses the relationship between total debt and shareholders' equity?
Which ratio assesses the relationship between total debt and shareholders' equity?
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Why is long-term debt-paying ability important for creditors?
Why is long-term debt-paying ability important for creditors?
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What does it mean for a debt to be backed by collateral?
What does it mean for a debt to be backed by collateral?
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How long do long-term debts typically have to be repaid?
How long do long-term debts typically have to be repaid?
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Which of the following is NOT considered a type of long-term debt?
Which of the following is NOT considered a type of long-term debt?
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Which of the following denotes financial risk associated with excessive long-term debt?
Which of the following denotes financial risk associated with excessive long-term debt?
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How can high levels of long-term debt affect a company’s solvency?
How can high levels of long-term debt affect a company’s solvency?
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Which key ratio measures a company's ability to pay long-term debt?
Which key ratio measures a company's ability to pay long-term debt?
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What should be excluded when calculating recurring income for Times Interest Earned?
What should be excluded when calculating recurring income for Times Interest Earned?
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What is a potential consequence of high long-term debts during economic downturns?
What is a potential consequence of high long-term debts during economic downturns?
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When assessing long-term debts, which factor is crucial for determining repayment ability?
When assessing long-term debts, which factor is crucial for determining repayment ability?
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Which of the following is NOT a characteristic of secured bonds?
Which of the following is NOT a characteristic of secured bonds?
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What is the primary indicator of interest coverage when analyzing historical data?
What is the primary indicator of interest coverage when analyzing historical data?
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Which type of liabilities should be included when calculating the debt ratio?
Which type of liabilities should be included when calculating the debt ratio?
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When analyzing fixed charge coverage, which portion of operating lease payments is generally approximated for inclusion?
When analyzing fixed charge coverage, which portion of operating lease payments is generally approximated for inclusion?
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In analyzing the debt ratio, which of the following liabilities is typically excluded?
In analyzing the debt ratio, which of the following liabilities is typically excluded?
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What does a higher debt ratio indicate about a firm?
What does a higher debt ratio indicate about a firm?
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When performing a secondary analysis for interest coverage, which expenses should be considered?
When performing a secondary analysis for interest coverage, which expenses should be considered?
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What is the recommended comparator for assessing a firm's debt ratio?
What is the recommended comparator for assessing a firm's debt ratio?
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Which of the following statements about the debt ratio is FALSE?
Which of the following statements about the debt ratio is FALSE?
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What are reserves in financial statements?
What are reserves in financial statements?
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How are deferred income taxes recognized according to GAAP?
How are deferred income taxes recognized according to GAAP?
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What is the treatment of noncontrolling interest in financial ratios?
What is the treatment of noncontrolling interest in financial ratios?
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What is the status of redeemable preferred stock in terms of disclosure?
What is the status of redeemable preferred stock in terms of disclosure?
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Which statement about noncontrolling interest is correct?
Which statement about noncontrolling interest is correct?
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How are reserves typically treated in US GAAP statements?
How are reserves typically treated in US GAAP statements?
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What does the presence of deferred income taxes signify?
What does the presence of deferred income taxes signify?
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Which of the following accurately describes redeemable preferred stock?
Which of the following accurately describes redeemable preferred stock?
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What does the Debt/Equity Ratio primarily assess?
What does the Debt/Equity Ratio primarily assess?
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Why is the Debt to Tangible Net Worth Ratio considered more conservative?
Why is the Debt to Tangible Net Worth Ratio considered more conservative?
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Which of the following best describes the significance of a low Debt to Tangible Net Worth Ratio?
Which of the following best describes the significance of a low Debt to Tangible Net Worth Ratio?
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How is Tangible Net Worth calculated?
How is Tangible Net Worth calculated?
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What is indicated by a high Debt/Equity Ratio?
What is indicated by a high Debt/Equity Ratio?
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What does the Debt/Equity Ratio help determine regarding creditors?
What does the Debt/Equity Ratio help determine regarding creditors?
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If a company has $1 million in total debt and $2 million in total equity, what is its Debt/Equity Ratio?
If a company has $1 million in total debt and $2 million in total equity, what is its Debt/Equity Ratio?
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When comparing Debt/Equity Ratios, what is typically considered?
When comparing Debt/Equity Ratios, what is typically considered?
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What does the current debt/net worth ratio indicate?
What does the current debt/net worth ratio indicate?
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How does a lower total capitalization ratio affect a company's risk?
How does a lower total capitalization ratio affect a company's risk?
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What is indicated by a fixed asset/equity ratio of 0.6?
What is indicated by a fixed asset/equity ratio of 0.6?
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What limitation exists when analyzing a company's long-term debt-paying ability?
What limitation exists when analyzing a company's long-term debt-paying ability?
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If a company has a high fixed asset/equity ratio, what could this imply?
If a company has a high fixed asset/equity ratio, what could this imply?
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What is total capitalization comprised of?
What is total capitalization comprised of?
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Why might certain assets have a greater market value than carrying value?
Why might certain assets have a greater market value than carrying value?
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Study Notes
Financial Reporting & Analysis
- The book is titled "Financial Reporting & Analysis: Using Financial Accounting Information" by Charles H. Gibson
- Copyright is 2013 Cengage Learning
Chapter 5: Long-Term Debt-Paying Ability
- Learning Objectives
- Define long-term debt and its significance in a company's financial structure
- Explain the importance of long-term debt-paying ability for creditors, investors, and management
- Analyze key financial ratios used to assess long-term debt-paying ability (Debt to Equity Ratio, Times Interest Earned (TIE) Ratio, Debt to Tangible Net Worth Ratio, and Fixed Charge Coverage Ratio)
Definition of Long-Term Debt
- Long-term debt are loans and financial obligations that a company is required to repay in more than one year.
- This includes bonds, loans from financial institutions, and other borrowings with repayment schedules that extend past 12 months.
Characteristics of Long-Term Debt
- Maturity Period: Repayment schedules typically extend beyond one year, ranging from a few years to several decades
- Interest Payments: Companies usually make periodic interest payments that can be either fixed or variable, depending on agreed terms
- Collateral: Some long-term debt (like mortgages or secured bonds) is secured by collateral, meaning specific company assets are pledged as security
Risks Associated with Long-Term Debt
- Financial Risk: Excessive long-term debt increases risk by burdening the company with fixed interest and principal repayments, particularly if revenues or profits decline
- Solvency Issues: High levels of long-term debt relative to equity or earnings threaten the company's ability to meet financial obligations, especially during economic downturns.
Examples of Key Ratios
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Times Interest Earned: Indicates long-term debt-paying ability by considering recurring income, excluding discontinued operations, extraordinary items, and including capitalized interest. Comparisons of historical data (3-5 years), industry competitors and averages, and secondary analysis are necessary
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Fixed Charge Coverage: Indicates a firm's ability to cover fixed charges. Includes the interest portion of operating lease payments. A general approximation is to include one-third of payments
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Debt Ratio: Indicates the firm's long-term debt-paying ability; includes short-term liabilities, reserves, deferred tax liability, noncontrolling interests, redeemable preferred stock, and other non-current liabilities. This ratio shows the percentage of assets financed by creditors
- Comparisons: Competitor and industry averages. Variations in application include excluding short-term liabilities (as they are not part of long-term financing) and including liabilities that do not present a future commitment to pay
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Certain Liabilities:
- Reserves: Often matched with an expense, but do not represent future payment commitments and are infrequently used in US GAAP statements
- Deferred Income Taxes: Differences in income tax expenses and payable income taxes. Recognized as a liability under GAAP, and included in the ratio
- Noncontrolling Interest: Represents the proportion of a consolidated entity not owned by the controlling parent company. It appears on the balance sheet as part of stockholders' equity. Some companies exclude it in calculations as it doesn't represent a commitment to pay funds to outsiders. However, it's included in the ratio for conservative applications.
- Redeemable Preferred Stock: Not disclosed under stockholders' equity, excluded from the ratio, but included in the ratio for conservative applications.
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Debt/Equity Ratio: Determines the entity's long-term debt-paying ability and how well creditors are protected in case of insolvency. Comparisons with competitors and industry averages are necessary.
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Debt to Tangible Net Worth Ratio: Determines the entity's long-term debt-paying ability and how well creditors are protected in case of insolvency. This ratio is more conservative than debt ratio and debt/equity due to the exclusion of intangibles. Formula:
(Total Liabilities) / (Shareholders' Equity - Intangible Assets)
Other Long-Term Debt-Paying Ratios
- Current Debt/Net Worth Ratio: Indicates a relationship between current liabilities and shareholder-provided funds. A higher proportion of funds provided by current liabilities indicates greater risk.
- Total Capitalization Ratio: This compares long-term debt to total capitalization (long-term debt, preferred stock, and common stockholders' equity). A lower ratio signifies lower risk.
- Fixed Asset/Equity Ratio: Shows the extent to which shareholders have funded fixed assets. A higher proportion of funds invested in fixed assets may indicate less flexibility and potential difficulties in generating liquidity.
Long-Term Assets versus Long-Term Debt
- Analyzing long-term debt-paying ability requires considering company assets, but financial statements do not always disclose market or liquidation values.
- Certain assets that have greater market values than their carrying amounts, and those with earning potential in the future should also be considered when reviewing debt-paying ability
Long-Term Leasing
- Capital Leases: Assets and liabilities are recorded on the balance sheet.
- Operating Leases: Reported as an expense on the income statement.
- Future lease payments are analyzed to assess long-term debt-paying ability. One-third is estimated as interest; two-thirds are added to fixed assets and long-term liabilities for debt ratio analysis.
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Description
This quiz covers Chapter 5 of 'Financial Reporting & Analysis: Using Financial Accounting Information' by Charles H. Gibson. It focuses on long-term debt, its significance in financial structures, and key financial ratios to assess long-term debt-paying ability. Test your understanding of concepts like Debt to Equity Ratio and Times Interest Earned.
