Chapter 9, Problem 5PSA

Shown here are condensed income statements for two different companies (both are organized as LLCs and pay no income taxes).

Required

1. Compute times interest earned for Miller Company.
2. Compute times interest earned for Weaver Company.
3. What happens to each company’s net income if sales increase by 30%?
4. What happens to each company’s net income if sales increase by 50%?
5. What happens to each company’s net income if sales increase by 80%?
6. What happens to each company’s net income if sales decrease by 10%?
7. What happens to each company’s net income if sales decrease by 20%?
8. What happens to each company’s net income if sales decrease by 40%?
Analysis Component

9. Comment on the results from parts 3 through 8 in relation to the fixed-cost strategies of the two companies and the ratio values you computed in parts 1 and 2.

Summary Introduction

Introduction: The income statement also known as the profit and loss statement which consists of operating and non-operating expenses which are deducted from the revenue generated from the sales. The time’s interest earned refers to the ratio of income before interest and taxes to interest earned.

To calculate: Times interest earned for company M.

Explanation of Solution

Computation of times interest earned for company M;

  $\begin{array}{c}\text{Times interest earned=}\frac{\text{Earning before Interest and Tax}}{\text{Interest Earned}}\\ =\frac{\$200,000}{\$60,000}\\ =3.3\text{times}\end{array}$

Summary Introduction

Introduction: The income statement also known as the profit and loss statement which consists of operating and non-operating expenses which are deducted from the revenue generated from the sales. The time’s interest earned refers to the ratio of income before interest and taxes to interest earned.

To calculate: Times interest earned for company W.

Explanation of Solution

Computation of times interest earned for company W:

  $\begin{array}{c}\text{Times interest earned=}\frac{\text{Earning before Interest and Tax}}{\text{Interest Earned}}\\ =\frac{\$400,000}{\$260,000}\\ =1.5\text{times}\end{array}$

Summary Introduction

Introduction: The net income refers to that part of income which is generated after subtracting all expenses such as cost of goods sold and other non-operating expenses, depreciation and taxes.

To calculate: The net income of each company if the sales increased by 30%.

Explanation of Solution

If sales increased by 30% for each company,

For company M;

  $\begin{array}{c}\text{Increase in Sales = Sales }\times \frac{30}{100}\\ \text{= \$1,000,000 }\times \frac{30}{100}\\ =\$300,000\end{array}$

  $\text{New Sales = Old Sales + Increase in Sales}$

  $\begin{array}{c}\text{New sales}=\$1,000,000+\$300,000\\ =\$1,300,000\end{array}$

For company W:

  $\begin{array}{c}\text{Increase in Sales = Sales }\times \frac{30}{100}\\ \text{ = \$1,000,000 }\times \frac{30}{100}\\ =\$300,000\end{array}$

  $\text{New Sales = Old Sales + Increase in Sales}$

  $\begin{array}{c}\text{New sales}=\$1,000,000+\$300,000\\ =\$1,300,000\end{array}$

Computing net income for company M:

Particular	Amount
Sales	$1,300,000
Less: variable expense (80%)	(1,040,000)
Income before interest	260,000
Less: Interest expense(fixed)	(60,000)
Net income	$200,000

Computing net income for company W:

Particular	Amount
Sales	$1,300,000
Less: variable expense (60%)	(780,000)
Income before interest	520,000
Less: Interest expense(fixed)	(260,000)
Net income	$260,000

Summary Introduction

Introduction: The net income refers to that part of income which is generated after subtracting all expenses such as cost of goods sold and other non-operating expenses, depreciation and taxes.

To calculate: The net income of each company if the sales increased by 50%.

Explanation of Solution

If sales increased by 50% for each company,

For company M:

  $\begin{array}{c}\text{Increase in Sales = Sales }\times \frac{50}{100}\\ \text{ = \$1,000,000 }\times \frac{50}{100}\\ =\$500,000\end{array}$

  $\text{New Sales = Old Sales + Increase in Sales}$

  $\begin{array}{c}\text{New sales}=\$1,000,000+\$500,000\\ =\$1,500,000\end{array}$

For company W:

  $\begin{array}{c}\text{Increase in Sales = Sales }\times \frac{50}{100}\\ \text{ = \$1,000,000 }\times \frac{50}{100}\\ =\$500,000\end{array}$

  $\text{New Sales = Old Sales + Increase in Sales}$

  $\begin{array}{c}\text{New sales}=\$1,000,000+\$500,000\\ =\$1,500,000\end{array}$

Computing net income for company M:

Particular	Amount
Sales	$1,500,000
Less: variable expense (80%)	(1,200,000)
Income before interest	3,000,000
Less: Interest expense(fixed)	(60,000)
Net income	$240,000

Computing net income for company W:

Particular	Amount
Sales	$1,300,000
Less: variable expense (60%)	(900,000)
Income before interest	400,000
Less: Interest expense(fixed)	(260,000)
Net income	$140,000

Summary Introduction

Introduction: The net income refers to that part of income which is generated after subtracting all expenses such as cost of goods sold and other non-operating expenses, depreciation and taxes.

To calculate: The net income of each company if the sales increased by 80%.

Explanation of Solution

If sales increased by 80% for each company,

For company M;

  $\begin{array}{c}\text{Increase in Sales = Sales }\times \frac{80}{100}\\ \text{ = \$1,000,000 }\times \frac{80}{100}\\ =\$800,000\end{array}$

  $\text{New Sales = Old Sales + Increase in Sales}$

  $\begin{array}{c}\text{New sales}=\$1,000,000+\$800,000\\ =\$1,800,000\end{array}$

For company W:

  $\begin{array}{c}\text{Increase in Sales = Sales }\times \frac{80}{100}\\ \text{ = \$1,000,000 }\times \frac{80}{100}\\ =\$800,000\end{array}$

  $\text{New Sales = Old Sales + Increase in Sales}$

  $\begin{array}{c}\text{New sales}=\$1,000,000+\$800,000\\ =\$1,800,000\end{array}$

Computing net income for company M:

Particular	Amount
Sales	$1,800,000
Less: variable expense (80%)	(1,440,000)
Income before interest	360,000
Less: Interest expense(fixed)	(60,000)
Net income	$300,000

Computing net income for company W:

Particular	Amount
Sales	$1,800,000
Less: variable expense (60%)	(1,080,000)
Income before interest	720,000
Less: Interest expense(fixed)	(260,000)
Net income	$460,000

Summary Introduction

Introduction: The net income refers to that part of income which is generated after subtracting all expenses such as cost of goods sold and other non-operating expenses, depreciation and taxes.

To calculate: The net income of each company if the sales decreased by 10%.

Explanation of Solution

If sales decreased by 10% for each company,

For company M;

  $\begin{array}{c}\text{Decrease in Sales = Sales }\times \frac{10}{100}\\ \text{ = \$1,000,000 }\times \frac{10}{100}\\ =\$100,000\end{array}$

  $\text{New Sales = Old Sales }-\text{ Decrease in Sales}$

  $$

  $\begin{array}{c}\text{New sales}=\$1,000,000-\$100,000\\ =\$900,000\end{array}$

For company W:

  $\begin{array}{c}\text{Decrease in Sales = Sales }\times \frac{10}{100}\\ \text{ = \$1,000,000}\times \frac{10}{100}\\ =\$100,000\end{array}$

  $\text{New Sales = Old Sales }-\text{ Decrease in Sales}$

  $\begin{array}{c}\text{New sales}=\$1,000,000-100,000\\ =\$900,000\end{array}$

Computing net income for company M:

Particular	Amount
Sales	$900,000
Less: variable expense (80%)	(720,000)
Income before interest	180,000
Less: Interest expense(fixed)	(60,000)
Net income	$120,000

Computing net income for company W:

Particular	Amount
Sales	$900,000
Less: variable expense (60%)	(540,000)
Income before interest	360,000
Less: Interest expense(fixed)	(260,000)
Net income	$100,000

Summary Introduction

Introduction: The net income refers to that part of income which is generated after subtracting all expenses such as cost of goods sold and other non-operating expenses, depreciation and taxes.

To calculate: The net income of each company if the sales decreased by 10%.

Explanation of Solution

If sales decreased by 20% for each company,

For company M;

  $\begin{array}{c}\text{Decrease in Sales = Sales }\times \frac{20}{100}\\ \text{ = \$1,000,000 }\times \frac{20}{100}\\ =\$200,000\end{array}$

  $\text{New Sales = Old Sales }-\text{ Decrease in Sales}$

  $$

  $\begin{array}{c}\text{New sales}=\$1,000,000-\$200,000\\ =\$800,000\end{array}$

For company W:

  $\begin{array}{c}\text{Decrease in Sales = Sales }\times \frac{20}{100}\\ =\text{\$1,000,000 }\times \frac{20}{100}\\ =\$200,000\end{array}$

  $\text{New Sales = Old Sales - Decrease in Sales}$

  $\begin{array}{c}\text{New sales}=\$1,000,000-\$200,000\\ =\$800,000\end{array}$

Computing net income for company M:

Particular	Amount
Sales	$800.000
Less: variable expense (80%)	(640,000)
Income before interest	160,000
Less: Interest expense(fixed)	(60,000)
Net income	$100,000

Computing net income for company W:

Particular	Amount
Sales	$800,000
Less: variable expense (60%)	(480,000)
Income before interest	320,000
Less: Interest expense(fixed)	(260,000)
Net income	$60,000

Summary Introduction

Introduction: The net income refers to that part of income which is generated after subtracting all expenses such as cost of goods sold and other non-operating expenses, depreciation and taxes.

To calculate: The net income of each company if the sales decreased by 10%.

Explanation of Solution

If sales decreased by 40% for each company,

For company M;

  $\begin{array}{c}\text{Decrease in sales = Sales }\times \frac{40}{100}\\ \text{ = \$1,000,000 }\times \frac{40}{100}\\ =\$400,000\end{array}$

  $\text{New Sales = Old Sales }-\text{ Decrease in Sales}$

  $\begin{array}{c}\text{New sales}=\$1,000,000-\$400,000\\ =\$600,000\end{array}$

For company W:

  $\begin{array}{c}\text{Decrease in sales = Sales }\times \frac{40}{100}\\ \text{ = \$1,000,000 }\times \frac{40}{100}\\ =\$400,000\end{array}$

  $\text{New Sales = Old Sales }-\text{ Decrease in Sales}$

  $\begin{array}{c}\text{New sales}=\$1,000,000-\$400,000\\ =\$600,000\end{array}$

Computing net income for company M:

Particular	Amount
Sales	$600,000
Less: variable expense (80%)	(480,000)
Income before interest	120,000
Less: Interest expense(fixed)	(60,0000)
Net income	$60,000

Computing net income for company W:

Particular	Amount
Sales	$60,0000
Less: variable expense (60%)	(360,000)
Income before interest	240,000
Less: Interest expense(fixed)	(260,000)
Net income	($20,000)

Summary Introduction

Introduction: The net income refers to that part of income which is generated after subtracting all expenses such as cost of goods sold and other non-operating expenses, depreciation and taxes.

The time's interest earned refers to the ratio of income before interest and taxes to interest earned.

To comment: On the result for interest earned by both the companies and for part 3 to 8.

Explanation of Solution

Comments on times interest earned by both the companies are:

The time's interest earned by company M is 3.3 times which indicates a healthy position to invest in the company from the investor point of view.

For company W:

The time's interest earned by the company W is 1.5 times which lesser than 2.5 times this indicates the riskier to invest in the company from an investor point of view.

Comments on the fixed cost strategies for the company The company fixed cost is decreasing the net income of the company on different sales revenue. This leads the company W to lose on 40% sales.