Chapter 9, Problem 5PSB

To determine

Times interest earned:

Times interest earned measures whether the company is in position to pay its debt obligations or not. It is also known as Interest Coverage Ratio.

1.

To compute: Times interest earned of E company.

Explanation of Solution

Given,

For E company

Income before interest is $120,000.

Interest expense is $90,000.

Times interest earned

Formula to calculate times interest earned,

  $\text{Times}\text{interest}\text{earned}=\frac{\text{Income}\text{before}\text{interest}\text{and}\text{tax}}{\text{Interest}\text{expense}}$

Substitute $120,000 for income before interest and tax and $90,000 for interest expense.

  $\begin{array}{c}\text{Times}\text{interest}\text{earned}=\frac{\$120,000}{\$90,000}\\ =1.33\text{Times}\end{array}$

Thus, times interest earned of E company is 1.33 times.

2.

To determine

To compute: Times interest earned of S company.

Explanation of Solution

Given,

For S company

Income before interest is $60,000.

Interest expense is $30,000.

Times interest earned

Formula to calculate times interest earned,

  $\text{Times}\text{interest}\text{earned}=\frac{\text{Income}\text{before}\text{interest}\text{and}\text{tax}}{\text{Interest}\text{expense}}$

Substitute $60,000 for income before interest and tax and $30,000 for interest expense.

  $\begin{array}{c}\text{Times}\text{interest}\text{earned}=\frac{\$60,000}{\$30,000}\\ =2\text{Times}\end{array}$

Thus, times interest earned of S company is 2 times.

3.

To determine

To compute: Net income if sales increase by 10%.

Explanation of Solution

Net income if sales increase by 10%.

Particulars	E Company ($)(given)	E Company ($)(10% increased sales)	S Company ($)(given)	S Company ($)(10% increased sales)
Sales	240,000	264,000	240,000	264,000
Variable expenses	120,000	132,000	180,000	198,000
Income before interest	120,000	132,000	60,000	66,000
Interest expense	90,000	90,000	30,000	30,000
Net Income	30,000	42,000	30,000	36,000
Increase in net income		40%		20%

Table (1)

Working note:

Formula to calculate percentage increase in net income is,

  $\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\text{Increase}\text{in}\text{net}\text{Income}}{\text{Prior}\text{net}\text{income}}$

For Company E

  $\begin{array}{c}\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\$12,000}{\text{\$30,000}}\\ =40\%\end{array}$

For Company S

  $\begin{array}{c}\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\text{\$6,000}}{\text{\$30,000}}\\ =20\%\end{array}$

Thus, net income of company E gets increased by 40% and company S by 20%.

4.

To determine

To compute: Net income if sales increase by 40%.

Explanation of Solution

Net income if sales increase by 40%.

Particulars	E Company ($)(given)	E Company ($)(40% increased sales)	S Company ($)(given)	S Company ($)(40% increased sales)
Sales	240,000	336,000	240,000	336,000
Variable expenses	120,000	168,000	180,000	252,000
Income before interest	120,000	168,000	60,000	84,000
Interest expense	90,000	90,000	30,000	30,000
Net Income	30,000	78,000	30,000	54,000
Increase in net income		160%		80%

Table (1)

Working Note:

Formula to calculate percentage increase in net income is,

  $\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\text{Increase}\text{in}\text{net}\text{Income}}{\text{Prior}\text{net}\text{income}}$

For Company E

  $\begin{array}{c}\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\$48,000}{\text{\$30,000}}\\ =160\%\end{array}$

For Company S

  $\begin{array}{c}\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\text{\$24,000}}{\text{\$30,000}}\\ =80\%\end{array}$

Thus, net income of company E gets increased by 160% and company S by 80%.

5.

To determine

To compute: Net income if sales increase by 90%.

Explanation of Solution

Net income if sales increase by 90%.

Particulars	E Company ($)(given)	E Company ($)(90% increased sales)	S Company ($)(given)	S Company ($)(90% increased sales)
Sales	240,000	456,000	240,000	456,000
Variable expenses	120,000	228,000	180,000	342,000
Income before interest	120,000	228,000	60,000	114,000
Interest expense	90,000	90,000	30,000	30,000
Net Income	30,000	138,000	30,000	84,000
Increase in net income		360%		180%

Table (1)

Working note:

Formula to calculate percentage increase in net income is,

  $\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\text{Increase}\text{in}\text{net}\text{Income}}{\text{Prior}\text{net}\text{income}}$

For Company E

  $\begin{array}{c}\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\$108,000}{\text{\$30,000}}\\ =360\%\end{array}$

For Company S

  $\begin{array}{c}\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\text{\$54,000}}{\text{\$30,000}}\\ =180\%\end{array}$

Thus, net income of company E gets increased by 360% and company S by 180%.

6.

To determine

To compute: Net income if sales decrease by 20%.

Explanation of Solution

Net income if sales decrease by 20%.

Particulars	M Company ($)(given)	M Company ($)(20% decreased sales)	S Company ($)(given)	W Company ($)(20% decreased sales)
Sales	240,000	192,000	240,000	192,000
Variable expenses	120,000	96,000	180,000	144,000
Income before interest	120,000	96,000	60,000	48,000
Interest expense	90,000	90,000	30,000	30,000
Net Income	30,000	6,000	30,000	18,000
Increase in net income		-80%		-40%

Table (1)

Working note:

Formula to calculate percentage increase in net income is,

  $\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\text{Increase}\text{in}\text{net}\text{Income}}{\text{Prior}\text{net}\text{income}}$

For Company E

  $\begin{array}{c}\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\$24,000}{\text{\$30,000}}\\ =-80\%\end{array}$

For Company S

  $\begin{array}{c}\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\text{\$12,000}}{\text{\$30,000}}\\ =-40\%\end{array}$

Thus, Net Income of company E gets decreased 80% and company S by 40%.

7.

To determine

To compute: Net income if sales decrease by 50%.

Explanation of Solution

Net income if sales decrease by 50%.

Particulars	E Company ($)(given)	E Company ($)(50% decreased sales)	S Company ($)(given)	S Company ($)(50% decreased sales)
Sales	240,000	120,000	240,000	120,000
Variable expenses	120,000	60,000	180,000	90,000
Income before interest	120,000	60,000	60,000	30,000
Interest expense	90,000	90,000	30,000	30,000
Net Income	30,000	(30,000)	30,000	0
Increase in net income		-200%		-100%

Table (1)

Working Note:

Formula to calculate percentage increase in net income is,

  $\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\text{Increase}\text{in}\text{net}\text{Income}}{\text{Prior}\text{net}\text{income}}$

For Company E

  $\begin{array}{c}\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\$60,000}{\text{\$30,000}}\\ =-200\%\end{array}$

For Company S

  $\begin{array}{c}\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\text{\$30,000}}{\text{\$30,000}}\\ =-100\%\end{array}$

Thus, Net Income of company E gets decreased 200% and company S by 100%.

8.

To determine

To compute: Net income if sales decrease by 80%.

Explanation of Solution

Net income if sales decrease by 80%.

Particulars	E Company ($)(given)	E Company ($)(80% decreased sales)	S Company ($)(given)	S Company ($)(80% decreased sales)
Sales	240,000	48,000	240,000	48,000
Variable expenses	120,000	24,000	180,000	36,000
Income before interest	120,000	24,000	60,000	12,000
Interest expense	90,000	90,000	30,000	30,000
Net Income	30,000	(66,000)	30,000	(18,000)
Increase in net income		-320%		-160%

Table (1)

Working note:

Formula to calculate percentage increase in net income is,

  $\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\text{Increase}\text{in}\text{net}\text{Income}}{\text{Prior}\text{net}\text{income}}$

For Company E

  $\begin{array}{c}\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\$96,000}{\text{\$30,000}}\\ =-320\%\end{array}$

For Company S

  $\begin{array}{c}\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\text{\$48,000}}{\text{\$30,000}}\\ =-160\%\end{array}$

Thus, Net Income of company E gets decreased 320% and company S by 160%.

9.

To determine

Relation to fixed cost strategies of the two companies

Explanation of Solution

Relation to fixed cost strategies of the two companies

• Here in this case fixed cost refers to interest expenses.
• Interest expenses in company E are $ 90,000 and in company S are $30,000. Interest expenses are higher in company E than in company S
• Due to higher interest expenses, change in net income gets more effected due to change in sales.
• Higher fixed cost is inversely related to times interest earned method.
• So if sales get increased, E company enjoys higher percent increase in income in comparison to company S
• If sales get decreased, S company experiences smaller percent change in net income in comparison to company E.