Question

Solvency Analysis

The following information is available from the balance sheets at the ends of the two most recent years and the income statement for the most recent year of Impact Company:

		December 31
		2017		2016
Accounts payable		$ 65,000		$ 50,000
Accrued liabilities		25,000		35,000
Taxes payable		60,000		45,000
Short-term notes payable		0		75,000
Bonds payable due within next year		200,000		200,000
Total current liabilities		$ 350,000		$ 405,000
Bonds payable		$ 600,000		$ 800,000
Common stock, $10 par		$1,000,000		$1,000,000
Retained earnings		650,000		500,000
Total stockholders’ equity		$1,650,000		$1,500,000
Total liabilities and stockholders’ equity		$2,600,000		$2,705,000

		2017
Sales revenue		$1,600,000
Cost of goods sold		950,000
Gross profit		$ 650,000
Selling and administrative expense		300,000
Operating income		$ 350,000
Interest expense		89,000
Income before tax		$ 261,000
Income tax expense		111,000
Net income		$ 150,000

Other Information:

1. Short-term notes payable represents a 12-month loan that matured in November 2017. Interest of 12% was paid at maturity.
2. One million dollars of serial bonds had been issued ten years earlier. The first series of $200,000 matured at the end of 2017, with interest of 8% payable annually.
3. Cash flow from operations was $185,000 in 2017. The amounts of interest and taxes paid during 2017 were $89,000 and $96,000, respectively.

Required:

1. Compute the following for Impact Company. Round your answers to two decimal places.

	2017		2016
a. The debt-to-equity ratio at December 31, 2017, and December 31, 2016	fill in the blank 1	to 1	fill in the blank 2	to 1
b. The times interest earned ratio for 2017	fill in the blank 3	to 1
c. The debt service coverage ratio for 2017	fill in the blank 4	times

2. The company's debt-to equity ratio has (increased/decreased). The ratio is (low/high) with respect to the equity of the company. The times interest earned ratio indicates that Impact's profits before interest and taxes were almost (twice/thrice/four times) the amount of (cash/assets/net income/interest payments). It is not wise to use the times interest earned ratio as the only indicator of solvency because it considers only the payment of (interest/principal) and not the payment of (interest/principal). In addition, these payments must be made with (cash/profits) not (cash/profits). The (accounts receivable turnover ratio/asset turnover ratio/profit margin/debt service coverage ratio) is a much better indication of the company's ability to meet its obligations because it looks at the (profits/cash from operations/assets).
Choose the correct answer.

Answer 1

Answer:

1.   a.   Debt-to-equity ratio: Total liabilities/Total stockholders’ equity

            At 12/31/17:    ($350,000 + $600,000)/$1,650,000

                                    = $950,000/$1,650,000 = 0.58 to 1

            At 12/31/17:    ($405,000 + $800,000)/$1,500,000

                                    = $1,205,000/$1,500,000 = 0.80 to 1

      b.   Times interest earned for 2017 (Net income + Interest expense + Income tax
expense)/Interest expense:

                  ($150,000 + $89,000 + $111,000)/$89,000 = $350,000/$89,000

                  = 3.93 to 1

      c.   Debt service coverage for 2017 (Cash flows from operations before interest and tax payments)/Interest and principal payments:

                  ($185,000 + $89,000 + $96,000*)/($89,000 + $275,000**)

                  = $370,000/$364,000 = 1.02 times

             *Taxes payable, 12/31/17 $    45,000

               Add: Tax expense                                       111,000

               Less: Taxes payable 12/31/17        (60,000)

               Taxes paid during 2017 $    96,000

            **Principal payments:

                  a.   Short-term notes payable               $    75,000

                  b.   Serial bonds                                        200,000

                        Total                                                 $275,000

2.         The company’s debt-to-equity ratio has decreased because of the repayment of the short-term notes and the installment payment on the serial bonds. The ratio at the end of 2017 of almost 0.6 to 1 indicates a relatively conservative balance of debt to stockholders’ equity. The times interest earned ratio indicates that Impact’s profits before interest and taxes were almost four times the amount of interest expense.

     

      Two problems arise, however, in using the times interest earned ratio as the sole measure of solvency. First, it considers the payment of only interest, not principal. Second, principal and interest payments must be made with cash, not profits. The debt service coverage ratio is a much better indication of the company’s ability to meet its obligations. A ratio of 1.02 times indicates that Impact generated just enough cash from operations to meet its principal and interest payments in 2017.