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Unformatted text preview: Chapter 7 Long-Term Debt-Paying Ability QUESTIONS 7-1. Yes, profitability is important to a firm’s long-term, debt-paying ability. Although the reported income does not agree with cash available in the short run, eventually the revenue and expense items do result in cash movements. Because there is a close relationship between the reported income and the ability of the entity to meet its long-run obligations, the major emphasis when determining the long-term, debt-paying ability is on the profitability of the entity. 7-2. (1) Income statement (2) Balance sheet The income statement approach is important because in the long run, there is usually a relationship between the reported income that is the result of accrual accounting and the ability of the firm to meet its long-term obligations. The balance sheet 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, then this indicates that the risks of the business have been shifted to outsiders. 7-3. A relatively high, stable coverage of interest over the years is desirable. A relatively low, fluctuating coverage of interest over the years is not desirable. 7-4. No. The auto manufacturing business is known for its cyclical nature. The times interest expense, therefore, would fluctuate materially. We would expect the auto manufacturer to finance a relatively small proportion of its long-term funds from debt. 7-5. A telephone company has its rate of return and, therefore, profits controlled by public utility commissions. We would expect the times interest earned to be moderate and relatively stable, which should be a relatively favorable times interest earned ratio. This stability allows for carrying a high portion of debt financing. 7-6. A firm must pay for the interest capitalized; therefore, this interest should be included along with interest expense in order to obtain total interest. 7-7. To get a better indication of a firm’s ability to cover interest payments in the short run, the noncash charges for depreciation, depletion, and amortization can be added back to the times interest earned numerator. The resulting income can be related to interest earned on a cash basis for a short-run indication of the firm’s ability to cover interest. 7-8. The financial statements are predominately prepared based upon historical cost. Seldom is the market value or liquidation value disclosed. 167 7-9. No, the determination of the current value of the long-term assets is very subjective. The best that can be achieved is a reasonable relationship of long-term assets to long-term debt, based on historical cost or estimates of current value....
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This note was uploaded on 12/20/2009 for the course COBA FIN302 taught by Professor Nejlaellili during the Spring '09 term at BA Mannheim.
- Spring '09