, Bear in mind that some expenses entering Into the determination of net income do not requIre immediate cash payments, Examples discussed in this chapter include deferred Income taxes and unfunded postretirement costs. The recognition of Such noncash expenses reduces net income to an amount less than the net cash flows resulting from operating activities during the period. liabilities and Financial Statement Disclosures A company should disclose the maturity dates of its major liabilities. These disclosures assist users of the financial statements in evaluating the company’s ability to meet obligations maturing in the near future. The FASB also requires companies to disclose the current value of most long-term liabilities. 14 This information helps users of the statements evaluate the likelihood of the company’s attempting to retire these liabilities prior to the scheduled maturity
EVALUATING THE SAFETY OF CREDITORS’ CLAIMS
L09 Evaiuate the safety of creditors’ claims. Creditors, of course, want to be sure that their claims are safe that is, that they will be paid on, time. Actually, everyone associated with a business-management, owners, employees- should be concerned with the company’s ability to pay its debts. If a business becomes insolvent (unable to ‘pay its obligations), it maybe forced into bankruptcy. Is Not only does management want the business to remain solvent, it wants the company to ‘maintain a high credit rating with agencies such as Dun & Bradstreet and Standard & Poor’s. A high credit rating helps a company borrow money more easily and at lower interest rates. In evaluating debt-paying ability, short-term creditors and long-term creditors look at different relationships. Short-term creditors are interested in the company’s immediate solvency. Long-term creditors, in contrast, are interested in the company’s ability to meet its interest obligations over a period of years, as well as its ability to repay or refinance large obligations as they come due. In previous we introduced several measures of short-term solvency and long-term credit risk.
These measures are summarized in the table on page 449-along with the interest coverage ratio, which is discussed below. Interest Coverage Ratio Creditors, investors, and managers all feel more comfortable when a company has enough income to cover its interest payments by a wide margin. One widely used measure of the relationship between earnings and interest expense is the interest coverage ratio The interest coverage ratio is computed by dividing operating income by the annual interest expense. From a creditor’s point of view, the higher this ratio, the better. In past years, most companies with good credit ratings had interest coverage ratios of, perhaps, 4 to 1 or more. With the spree of junk bond financing in the 1980s, many large corporations let their interest coverage ratios decline below 2 to 1.
In most cases, their credit ratings dropped accordingly. 14 Current value means either market value (as in the case of bonds payable) or the present value of the expected future payments (as with unfunded postretirement obligations), The current value disclosure requirement does not apply to a company’s obligation for deferred income taxes Bankruptcy is a legal status under which the company’s fate is determined largely by the U.S. Bankruptcy Court. Sometimes the company is reorganized and allowed to continue its operations. In other cases, the business is closed and its assets are sold. Often managers and employees lose their jobs. In almost all bankruptcies, the company’s creditors and owners incur legal costs and sustain financial losses.
Less Formal Means of Determining Creditworthiness Not all decisions to extend credit
involve formal analysis of the borrower’s financial statements. Most suppliers of goods or services, for example, will sell on account to almost any long-established business unless they know the customer to be in severe financial difficulty. If the customer is not a well-established business, these suppliers may investigate the customer’s credit history by contacting a credit-rating agency.In lending to small businesses organized as corporations, lenders may require key stockholders to personally guarantee repayment of the loan. How Much Debt Should a Business Have? All businesses incur some debts as a result of normal business operations. These include, for example, accounts payable and accrued liabilities. But many businesses aggressively use long-term debt, such as mortgages and bonds payable, to finance growth and expansion Is this wise? Does it benefit the stockholders? The answer hinges on another
question: Can the borrowed funds be invested to earn a return higher than the rate
interest paid to creditors? Using borrowed money to finance business operations is called applying leverage. Extensive use ofIeverage-s-that is, a great deal of debt sometimes benefits a business dramatically. But if things don’t work out, it can “wipe out” the borrower. If borrowed money can be invested to earn a rate of return higher than the interest rates paid to the lenders, net income and the return on stockholders’ equity will increase” For example, if you borrow money at an interest rate of 9% and invest it to earn 15%, you will benefit from “the spread.” But leverage is a double-edged sword the effects may be favorable or unfavorable. If the rate of return earned on the borrowed money falls below the rate of interest being paid, the use of borrowed money reduces net income and the return on equity. Companies with large amounts of debt sometimes become victims of their own debt-service requirements.