Week 6 – Assignment: Explain Financial Leverage
Research the impact of financial leverage on earnings and performance measures. Present, describe, and illustrate the leverage relation between earnings before interest and taxes (EBIT) and net income. Develop numerical examples to illustrate the concepts as you respond to the questions.
- Present, describe and illustrate the leverage relation between ROE and ROI. Develop numerical examples to illustrate the concepts.
- Present, describe and illustrate the leverage relation between EBIT and net income. Develop numerical examples to illustrate the concepts.
- Review the referenced paper by Lord. (1998). Describe the research question being addressed. Discuss the methods used and the conclusions reached by the study.
Support your paper with a minimum of five (5) external resources In addition to these specified resources, other appropriate scholarly resources, including older articles, may be included.
Length: 5-7 pages not including title and reference pages
Your paper should demonstrate thoughtful consideration of the ideas and concepts presented in the course and provide new thoughts and insights relating directly to this topic. Your response should reflect scholarly writing and current APA standards.
After completing the assignment see below:
Week 6 – Discussion: Describe and Explain Stakeholder Differences
Summarize your thoughts and ideas about three key financial metrics of interest to stockholders and then three key metrics of interest to one of the following groups: bankers, bondholders, managers, consumers, politicians. Being able to successfully describe and define the metrics effects will be beneficially in understanding and explaining how you could employ the metrics for future financial analyses. This discussion will be open-ended to afford you the opportunity to interact with your course instructor and possibly other students.
Length: Content post 150-200 words; response post 75-100 words.
Both your content post and your response post should reflect a collegial attitude, be free of grammar and spelling errors, and include criteria mentioned above.
Week 6 – Assignment: Explain Financial Leverage
Research the impact of financial leverage on earnings and performance measures. Present, describe, and illustrate the leverage relation between earnings before interest and taxes (EBIT) and net income. Develop numerical examples to illustrate the concepts as you respond to the questions.
1. Present, describe and illustrate the leverage relation between ROE and ROI. Develop numerical examples to illustrate the concepts.
2. Present, describe and illustrate the leverage relation between EBIT and net income. Develop numerical examples to illustrate the concepts.
3. Review the referenced paper by Lord. (1998). Describe the research question being addressed. Discuss the methods used and the conclusions reached by the study.
Support your paper with a minimum of five (5) external resources In addition to these specified resources, other appropriate scholarly resources, including older articles, may be included.
Length: 5-7 pages not including title and reference pages
Your paper should demonstrate thoughtful consideration of the ideas and concepts presented in the course and provide new thoughts and insights relating directly to this topic. Your response should reflect scholarly writing and current APA standards.
After completing the assignment see below:
Week 6 – Discussion: Describe and Explain Stakeholder Differences
Summarize your thoughts and ideas about three key financial metrics of interest to stockholders and then three key metrics of interest to one of the following groups: bankers, bondholders, managers, consumers, politicians. Being able to successfully describe and define the metrics effects will be beneficially in understanding and explaining how you could employ the metrics for future financial analyses. This discussion will be open-ended to afford you the opportunity to interact with your course instructor and possibly other students.
Length: Content post 150-200 words; response post 75-100 words.
Both your content post and your response post should reflect a collegial attitude, be free of grammar and spelling errors, and include criteria mentioned above.
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Chapter 7
Long-Term
Debt-Paying Ability
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2
Indicates long-term debt-paying ability
Consider only recurring income
Exclude discontinued operations
Exclude extraordinary items
Exclude (add back) to income
Interest and Income tax expenses
Equity losses (earnings) of nonconsolidated subsidiaries
Net income—Noncontrolling interest
Include interest capitalized
Times Interest Earned
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3
Times Interest Earned—Continued
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4
Comparisons
3 to 5 years of historical data
Lowest value is the primary indicator of interest coverage
Industry competitors and averages
Secondary analysis
Interest coverage on long-term debt
Use only interest on long-term debt
Short-run coverage
Add back noncash expenses to recurring income
Less conservative
Times Interest Earned—Continued
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5
Times Interest Earned- Short-Run Variation
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6
Indicates a firm’s ability to cover fixed charges
Fixed Charge Coverage
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7
Fixed charges include
Interest portion of operating lease payments
General approximation is to include 1/3 of payments
SEC requires specific calculation using lease terms
May also include
Depreciation, depletion, and amortization
Debt principal payments
Pension payments
Substantial preferred stock dividends
The more items included as “fixed charges,” the more conservative the ratio
Fixed Charge Coverage—Continued
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8
Indicates the firm’s long-term debt-paying ability
Total liabilities
Includes short-term liabilities, reserves, deferred tax liability, noncontrolling interests, redeemable preferred stock, and any other non current liability
Indicates the percentage of assets financed by creditors
Debt Ratio
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Comparisons
Competitors and industry averages
Variations in application
Short-term liabilities
Exclude as they are not part of long-term source of funds
Include as they become part of the total source of funds
Liabilities that do not necessarily represent a commitment to pay out funds in the future
Debt Ratio—Continued
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10
Reserves
Matches an expense but do not represent definite commitments to pay out funds in the future
Infrequently used in U.S. GAAP statements
Include in ratio for conservative application
Debt Ratio and Certain Liabilities
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11
Deferred Income Taxes
Difference between income tax expense and income taxes payable
Recognized as a liability by GAAP; include in ratio
A company reports deferred taxes as
A net current amount
A net noncurrent amount
Referred as soft accounts
Debt Ratio and Certain Liabilities—Continued
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Noncontrolling Interest
Proportion of a consolidated entity that is not owned by the controlling parent company
Appears on the balance sheet as part of stockholders’ equity
Some firms exclude from ratio as it does not represent a commitment to pay funds to outsiders
Included in ratio for conservative application
Debt Ratio and Certain Liabilities—Continued
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13
Redeemable Preferred Stock
Not disclosed under stockholders’ equity
Exclude from ratio; does not present a normal debt relationship
Included in ratio for conservative application
Debt Ratio and Certain Liabilities—Continued
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Determines the entity’s long-term debt-paying ability
Helps determine how well creditors are protected in case of insolvency
Comparisons
Competitors and industry averages
Debt/Equity Ratio
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15
Determines the entity’s long-term debt payment ability
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
Debt to Tangible Net Worth Ratio
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16
Current debt/net worth ratio
Indicates a relationship between current liabilities and funds contributed by shareholders
The higher the proportion of funds provided by current liabilities, the greater the risk
Total capitalization ratio
Compares long-term debt to total capitalization
Total capitalization consist of long-term debt, preferred stock, and common stockholders’ equity
The lower the ratio, the lower the risk
Other Long-Term Debt-Paying Ability Ratios
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17
Fixed asset/equity ratio
The extent to which shareholders have provided funds in relation to fixed assets
Subtracting intangibles from shareholders’ equity will result in more conservative ratio
The higher the fixed assets in relation to equity, the greater the risk
Other Long-Term Debt-Paying Ability Ratios—Continued
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Consider the assets of the firm when determining the long-term debt-paying ability
Ability for analysis is limited
Financial statements do not disclose market or liquidation value
Certain assets may have market value significantly greater then carrying value
Certain assets may have earnings potential in the future
Long-Term Assets versus Long-Term Debt
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19
Capital leases
Asset and liability are reported on the balance sheet
Operating leases
Reported as expense on the income statement
Supplemental analysis using future payments
One-third can be estimated as interest
Two-thirds can be added to the fixed assets and long-term liabilities for debt ratio analyses
Long-Term Leasing
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20
Employee Retirement Income Security Act (ERISA)
Includes provisions requiring
Minimum funding of plans
Minimum rights to employees upon termination of their employment
Creation of a special federal agency, the Pension Benefit Guaranty Corporation (PBGC)
Pension Plans
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21
Defines the contributions of the company to the pension plan
Employer bears no risk for future growth of plan
No complexity in estimating company’s pension liability or pension expense
401(k) is a type of defined contribution plan
Trend analysis
Compare three years of pension expense in relationship to operating revenue and income before income taxes; note any balance sheet items
Defined Contribution Plan
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22
Defines the benefits to be received by the participants in the plan
Employer must fund sufficiently to achieve benefit
Note actuarial assumptions inherent in the plan
Interest (discount) rates
Employee turnover
Mortality rates
Compensation
Pension benefits
Defined Benefit Plan
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23
Trend analysis
Compare three years of pension expense in relationship to operating revenue and income before income taxes
Compare benefit obligations to plan assets
Underfunding represents a potential liability
Overfunding represents an opportunity to reduce future pension expense and/or reduce related costs
Note the net balance sheet liability (asset) recognized
Defined Benefit Plan—Continued
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24
Prior to 1993, accrual was not required
Transition costs may be
Amortized over 20 years or
Expensed in the year of adopting the new recognition practice
Analysis is similar to defined benefit plans for pension
Postretirement Benefits
Other than Pensions
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25
An association of two or more businesses established for a special purpose
Consolidation
Done by the parent firm if it has control using a pro-rata share
Carried in an investment account
Analysis
Review footnote that relates to the joint venture
Off-balance sheet commitments represent potential liabilities
Joint Ventures
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26
An existing condition involving uncertainty as to possible gain or loss to an enterprise
Will be resolved when one or more future events occur or fail to occur
Loss contingencies that are not accrued are included in the footnotes
Gain contingencies are not accrued
Review contingency note for possible liabilities and gain contingencies not disclosed on the balance sheet
Contingencies
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27
Disclosure is required of
The face or contract amount
Nature and terms of the instrument
Amount of the potential loss
Entity’s collateral policy and description of the collateral it currently holds
Accounting loss occurs when
The co-party fails to perform the terms of contract
Changes in market make a instrument less valuable or more troublesome
Financial Instruments with
Off-Balance-Sheet Risk
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28
Disclosure is required of the extent of risk from exposures to individuals or groups of counterparties in the same industry or region
Small companies are particularly susceptible to concentration risk
Financial Instruments
with Concentrations of Credit Risk
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29
Disclosure of financial instrument’s fair value is required
On-balance sheet assets and liabilities
Off-balance sheet assets and liabilities
If estimation of fair value is not practicable
Descriptive information pertinent to estimating fair value is provided
Disclosures About
Fair Value of Financial Instruments
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30
Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Noncontrolling Interest
Times Interest Earned =
Interest Expense, Including Capitalized
Interest
(Recurring Earnings + Noncash Expense),
Excluding Interest Expense, Tax Expense,
Equity Earnings, and Noncontrolling Inte
rest
Times Interest Earned =
Interest Expense, Including Capitalized
Interest
Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Noncontrolling Interest + Interest
Portion of Rentals
Fixed Charge Coverage =
Interest Expense, Including Capitalized
In
terest + Interest Portion of Rentals
Total Liabilities
Debt Ratio =
Total Assets
Total Liabilities
Debt/Equity Ratio =
Shareholders’ Equity
Total Liabilitites
Debt to Tangible Net Worth Ratio =
Shareholders’ Equity Intangible Assets
–