Financial Reporting & Analysis Chapter 5

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

• 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

• 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

• 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
  • 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.

• 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.

• 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.