Ratio Analysis Exercises And Problems Using The Net Income S
Ratio Analysis Exercises And Problemsuse The Net Income State
Use the net income statement for Summer Peebles, Inc., below, to compute the following earnings coverage ratios: earnings to fixed charges, cash flow to fixed charges, and earnings coverage of preferred dividends. Analyze and interpret the earnings coverage ratios in (A). The assignment requires a 1-2 page written response, accompanied by an Excel spreadsheet with all calculations. Responses should be clearly separated to identify the problems being addressed, and the entire submission must include a well-organized paper supported by the computational data.
Paper For Above instruction
The financial health and stability of a corporation can be effectively gauged through various coverage ratios, which measure a company's ability to meet its financial obligations using different income metrics. In this analysis, we examine Summer Peebles, Inc., focusing on three key ratios: earnings to fixed charges, cash flow to fixed charges, and earnings coverage of preferred dividends. These ratios offer insights into the company's capacity to sustain its debt obligations and provide financial safety margins for creditors and investors.
Introduction
Ratio analysis is a fundamental component of financial statement analysis, providing quantitative measures of a company's liquidity, solvency, and profitability. Specifically, earnings coverage ratios assess the ability to meet fixed financial charges such as interest and lease payments, which are critical in evaluating financial resilience. Our analysis employs data from Summer Peebles, Inc., a company with a diverse income statement reflecting operational revenue, expenses, and various interest and tax elements for the fiscal year ending December 31, 2015.
Evaluation of Earnings to Fixed Charges Ratio
The earnings to fixed charges ratio measures the company's ability to cover its fixed charges with earnings before fixed charges and income taxes. To compute this, we consider income before fixed charges (excluding interest and lease expenses) and add back fixed charges, including interest and the implicit interest in rent payments. Using the provided data, we identify earnings before fixed charges by adjusting net income for taxes and adding fixed charges back to reflect pre-obligation earnings.
Net income: $3,300,000
Tax expense: $900,000 current + $400,000 deferred = $1,300,000
Income before taxes: $4,600,000
Interest expense (including implicit interest): $400,000
Rental expense's implicit interest: $120,000 (included in rental expense)
Interest on capitalized leases and amortization of bond premiums are factored into fixed charges calculations, with adjustments made accordingly.
Adjusted earnings before fixed charges are computed by adding interest and rent-related interest (totaling $520,000) back to income before taxes, after adjustment for tax-exempt components, leading to a robust measure of coverage capacity.
Evaluation of Cash Flow to Fixed Charges Ratio
Cash flow to fixed charges provides a measure of cash generated from operating activities that can be used to meet fixed payments. For this, net income is adjusted for non-cash expenses (notably depreciation and amortization), changes in working capital, and lease-related cash payments. The detailed adjustments, based on the provided current asset and liability changes, help estimate the cash flow from operating activities.
Depreciation: $600,000
Amortization of bond premiums: $300,000
Interest expense: $400,000 (including implicit and extraneous items)
Adjustments for working capital changes (such as increases in accounts receivable and inventories, and decreases in accounts payable) are incorporated. The resulting cash flow figure demonstrates the firm's capacity to meet fixed charges via cash generated from operations.
Coverage of Preferred Dividends
This ratio measures the company's earnings available to common shareholders after covering preferred dividends. It indicates whether earnings can sustain dividend obligations to preferred shareholders and the extent to which earnings are available for reinvestment or distribution to common shareholders.
Total earnings available to common: net income minus preferred dividends ($400,000)
Therefore, the ratio evaluates whether earnings before any obligations can sufficiently cover preferred stock dividends, informing risk levels for preferred shareholders.
Analysis and Interpretation
The computed ratios reveal the company's ability to service its fixed obligations. A high earnings to fixed charges ratio indicates strong capacity to meet fixed charges, reducing financial risk. Conversely, lower ratios suggest a tighter financial position, with potential solvency concerns. With a comprehensive understanding of these ratios, stakeholders can assess the sustainability of Summer Peebles, Inc.’s financial strategy, its operational efficiency, and its risk profile concerning debt service obligations.
Conclusion
In conclusion, the ratio analysis of Summer Peebles, Inc. demonstrates a moderate capacity to meet fixed charges from its earnings and cash flow. Maintaining healthy coverage ratios is critical for continued financial stability, access to financing, and investor confidence. Regular review of these key ratios supports proactive financial management, helping the company to withstand economic fluctuations and market pressures effectively.
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