Chapter 9: Decision Analysis: Times Interest Earned

Times Interest Earned Ratio and Its Analysis in Liability Management The Times Interest Earned (TIE) Ratio is a financial metric used to measure a company's ability to cover its interest expenses with its operating income. It’s especially useful for understanding the risks associated with fixed costs like interest, as these don’t vary with sales and can increase financial strain if revenue declines. 1. Formula for Times Interest Earned (TIE) Ratio • • The TIE Ratio is calculated as: TIE=Income Before Interest and Taxes (EBIT)Interest Expense A higher TIE ratio indicates a stronger ability to cover interest payments, with lower risk. For example, if a company’s TIE ratio is 2.5, it means that the company’s EBIT covers its interest expense 2.5 times over, reflecting a moderate financial risk. Ratios below 1.5 are considered risky, as they imply that the company’s income might not cover its interest expenses if revenue declines. 2. Example: Diego Co. • • Diego Co.’s 2021 TIE ratio is calculated as follows: TIE=15060=2.5 This ratio implies that Diego Co. has some cushion in covering its interest expenses, indicating a low to moderate risk level. However, if sales decline by 50%, Diego Co.’s ability to cover interest is significantly compromised, as reflected in the corresponding drop in net income. 3. Investment Decision Example • • For the franchise investment decision: o Franchise 1: TIE=100,000+200,000200,000=1.5 o Franchise 2: TIE=100,000+40,00040,000=3.5 The lower TIE ratio for Franchise 1 suggests higher risk, as it indicates a lower margin for covering fixed interest expenses compared to Franchise 2, which has a higher TIE and therefore a greater safety margin if sales do not meet projections. Practical Application: Kern Co. Transactions and Journal Entries a. Warranty Liability for Merchandise Sold • • • Warranty Expense: 5%×140,000=7,000 Journal Entry on September 30: o Debit: Warranty Expense $7,000 o Credit: Estimated Warranty Liability $7,000 Repair Entry on October 8: o o Debit: Estimated Warranty Liability $300 Credit: Cash $300 b. Overdue Account Replaced by Note Payable • • • October 12 Entry: o Debit: Accounts Payable $10,000 o Credit: Cash $2,500 o Credit: Notes Payable $7,500 Interest Calculation and Entry on December 31 (Accrued Interest): o Interest=12%×7,500×80360=200 o Debit: Interest Expense $200 o Credit: Interest Payable $200 Note Payment on January 10: o Remaining Interest=12%×7,500×10360=25 o Debit: Notes Payable $7,500 o Debit: Interest Expense $25 o Debit: Interest Payable $200 o Credit: Cash $7,725 c. Pending Product Liability Suit • Accounting Treatment: o Disclose in financial statement notes since the loss is probable but cannot be reasonably estimated. d. Payroll for Sally Bline • • Deductions: o Federal Income Tax: $800 o State Income Tax: $200 o FICA Social Security: 6.2%×3,000=186 o FICA Medicare: 1.45%×3,000=43.50 o Health Insurance: $35 o United Way Donation: $10 Journal Entry: o Debit: Salaries Expense $3,000 o Credit: FICA Social Security Payable $186 o Credit: FICA Medicare Payable $43.50 o Credit: Federal Income Tax Payable $800 o Credit: State Income Tax Payable $200 o Credit: Health Insurance Payable $35 o Credit: United Way Donation Payable $10 o Credit: Salaries Payable $1,725.50 e. Bank Loan Note • • November 1 Issuance: o Debit: Cash $5,000 o Credit: Notes Payable $5,000 Interest and Principal Repayment on December 31: o Interest=12%×5,000×60360=100 o Debit: Notes Payable $5,000 o Debit: Interest Expense $100 o Credit: Cash $5,100 f. Income Tax Adjustment • Additional Year-End Income Tax Adjustment: o Debit: Income Tax Expense $5,000 o Credit: Income Taxes Payable $4,000 o Credit: Deferred Income Taxes $1,000 These entries ensure accurate liability tracking, income smoothing, and proper disclosure, which provide stakeholders with transparency into a company's financial health and risk profile.