Chapter 11, Problem 7BTN

To determine

Times Interest Earned:

The ratio which measures a company’s ability to pay its obligation is called a times interest earned. It is computed by dividing the net income before interest and taxes by the interest expense of the company.

To determine:

1. Prepare an Income statement showing current operations, European and total when the sales at European location are $250,000.

2. Compute the times interest earned for expansion assumptions.

3. Prepare an Income statement showing current operations, European and total when the sales at European location are $400,000 and compute times interest earned.

4. Prepare an Income statement showing current operations, European and total when the sales at European location are $100,000 and compute times interest earned.

5. Comment on the results obtained in part 1 through 4.

Answer to Problem 7BTN

Solution:

1.

UNCHARTED PLAY Income Statement
	Current Operations	European	Total
Sales	$1,000,000	$250,000	$1,250,000
Operating Expenses (55%)	550,000	137,500	687,500
Income before interest and tax	450,000	112,500	562,500
Interest Expense		21,000	21,000
Net Income	$450,000	$91,500	$541,500

2.

When sales at European location are $250,000, the times interest earned is 26.79.

3.

UNCHARTED PLAY Income Statement
	Current Operations	European	Total
Sales	$1,000,000	$400,000	$1,400,000
Operating Expenses (55%)	550,000	220,000	770,000
Income before interest and tax	450,000	180,000	630,000
Interest Expense		21,000	21,000
Net Income	$450,000	$159,000	$609,000

When sales at European location are $400,000, the times interest earned is 30.

4.

UNCHARTED PLAY Income Statement
	Current Operations	European	Total
Sales	$1,000,000	$100,000	$1,100,000
Operating Expenses (55%)	550,000	55,000	605,000
Income before interest and tax	450,000	45,000	495,000
Interest Expense		21,000	21,000
Net Income	$450,000	$24,000	$474,000

When sales at European location are $100,000, the times interest earned is 23.57.

5. The times interest earned has direct relationship with the net income of the company. With Operating expense being constant, when the net income increases due to increase in sales, the times interest earned rises and when the net income decreases due to decrease in sales, the time interest earned also falls.

Explanation of Solution

Explanation:

1.

	Current Operations	European	Total
Sales	$1,000,000	$250,000	$1,250,000
55% of sale is operating expense	55%	55%	55%
Operating Expense	$550,000	$137,500	$687,500

Computation of interest expense
  $\begin{array}{l}PrincipalXRateofinterest\hfill \\ =\$300,000X0.07\hfill \\ =\$21,000\hfill \end{array}$

2. When the sales are 250,000

  $\begin{array}{l}TimesInterestEarnedforExpansion=\frac{NetIncome+InterestExpense}{InterestExpense}\hfill \\ =\frac{\$541,500+\$21,000}{\$21,000}\hfill \\ =\text{ 26}.79\hfill \end{array}$

3. When the sales are $400,000

  $\begin{array}{l}TimesInterestEarnedforExpansion=\frac{NetIncome+InterestExpense}{InterestExpense}\hfill \\ =\frac{\$609,000+\$21,000}{\$21,000}\hfill \\ =\text{ 30}\hfill \end{array}$

4. When the sales are $100,000

  $\begin{array}{l}TimesInterestEarnedforExpansion=\frac{NetIncome+InterestExpense}{InterestExpense}\hfill \\ =\frac{\$474,000+\$21,000}{\$21,000}\hfill \\ =\text{ 23}.57\hfill \end{array}$

Conclusion

Conclusion:

It is concluded that the times interest earned ratio depends upon the increase and decrease of net income and interest expense of a company.