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Ebook Financial reporting & analysis (11/E): Part 2

Part 1 book “Financial reporting &analysis” has contents: Long-Term debt-paying ability, profitability, for the investor, statement of cash flows, expanded analysis, special industries - banks, utilities, oil and gas, transportation, insurance, real estate companies, personal financial statements and accounting for governments and not-for-profit organizations. | Chapter 7 Long-Term Debt-Paying Ability T his chapter covers 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 debt as indicated by the balance sheet. In the long run, a relationship exists between the reported income resulting from the use of accrual accounting and the ability of the firm to meet its long-term obligations. Although the reported income does not agree with the cash available in the short run, the revenue and expense items eventually do result in cash movements. Because of the close relationship between the reported income and the ability of the firm to meet its long-run obligations, the entity’s profitability is an important factor when determining long-term debt-paying ability. In addition to the profitability of the firm, the amount of debt in relation to the size of the firm should be analyzed. This analysis indicates the amount of funds provided by outsiders in relation to those provided by owners of the firm. If a high proportion of the resources has been provided by outsiders, the risks of the business have been substantially shifted to the outsiders. A large proportion of debt in the capital structure increases the risk of not meeting the principal or interest obligation because the company may not generate adequate funds to meet these obligations. Income Statement Consideration when Determining Long-Term Debt-Paying Ability The firm’s ability to carry debt, as indicated by the income statement, can be viewed by considering the times interest earned and the fixed charge coverage. These ratios are now reviewed. TIMES INTEREST EARNED The times interest earned ratio 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