Chapter 11, Problem 5BPSB

To determine

Times Interest earned: Times interest earned is calculated by dividing income before interest and income tax by interest expense. This ratio shows the ratio of income earned by a company to amount of interest expenses, whether the company is earning enough to pay off its interest expenses. Thus, higher the ratio more capable is the company to pay off its interest expense. Formula for the same is given below:

$TimesInterestEarned=\frac{EarningsBeforeInterestAndTaxes}{InterestExpense}$

Requirement 1:

To determine:

Times interest earned ratio for Ellis Company using the formula as stated above.

Explanation of Solution

Times interest earned for Ellis Company.

$TimesInterestEarned=\frac{EarningsBeforeInterestAndTaxes}{InterestExpense}$

$\begin{array}{l}TimesInterestEarned=\frac{120000}{90000}\\ TimesInterestEarned=1.33Times\end{array}$

To determine

Requirement 2:

To determine:

Times interest earned ratio for Seidel Company using the formula as stated above.

Explanation of Solution

Times interest earned for Seidel Company

$TimesInterestEarned=\frac{EarningsBeforeInterestAndTaxes}{InterestExpense}$

$\begin{array}{l}TimesInterestEarned=\frac{60000}{30000}\\ TimesInterestEarned=2Times\end{array}$

To determine

Requirement 3:

To determine:

Changes If sales Increase by 30%.

Explanation of Solution

Ellis Company			Seidel Company
Sales	240000		Sales	240000
Add 10%	24000		Add 10%	24000
Total Sales	264000		Total Sales	264000
Sales	264000		Sales	264000
Variable Expense(50%)	132000		Variable Expense(75%)	198000
Income Before Interest	132000		Income Before Interest	66000
Interest(Fixed Expense)	90000		Interest(Fixed Expense)	30000
Net Income	42000		Net Income	36000

If sales are increased by 10%, Net income of Miller increases to $42000 from $30000 and Net Income of Weaver increases from $30000 to $36000.

To determine

Requirement 4:

To determine:

Changes If Sales increase by 50%

Explanation of Solution

Ellis Company			Seidel Company
Sales	240000		Sales	240000
Add 40%	96000		Add 40%	96000
Total Sales	336000		Total Sales	336000
Sales	336000		Sales	336000
Variable Expense(50%)	168000		Variable Expense(75%)	252000
Income Before Interest	168000		Income Before Interest	84000
Interest(Fixed Expense)	90000		Interest(Fixed Expense)	30000
Net Income	78000		Net Income	54000

If sales are increased by 40% Net Income of Miller company increased to $78000 from $30000 and net income of Weaver increases to $54000 from $30000.

To determine

Requirement 5:

To determine:

Changes If Sales Increase by 80%

Explanation of Solution

Ellis Company			Seidel Company
Sales	240000		Sales	240000
Add 90%	216000		Add 90%	216000
Total Sales	456000		Total Sales	456000
Sales	456000		Sales	456000
Variable Expense(50%)	228000		Variable Expense(75%)	342000
Income Before Interest	228000		Income Before Interest	114000
Interest(Fixed Expense)	90000		Interest(Fixed Expense)	30000
Net Income	138000		Net Income	84000

If sales increase to 90% net income of Miller Company increases to $138000 from $30000 and Weaver Company increases from $30000 to $84000.

To determine

Requirement 6:

To determine:

Changes If sales decrease by 10%

Explanation of Solution

Ellis Company				Seidel Company
Sales	240000			Sales		240000
Less 20%	48000			Less 20%		48000
Total Sales	192000			Total Sales		192000
Sales	192000			Sales		192000
Variable Expense(50%)	96000			Variable Expense(75%)		144000
Income Before Interest	96000			Income Before Interest		48000
Interest(Fixed Expense)	90000			Interest(Fixed Expense)		30000
Net Income	6000			Net Income		18000

If Sales decrease by 10%, Net income of Ellis reduces to $6000 from $30000 and Seidel Company, reduces from $18000 to $30000.

To determine

Requirement 7:

To determine:

Changes If sales decrease by 20%

Explanation of Solution

Ellis Company			Seidel Company
Sales	240000		Sales	240000
Less 50%	120000		Less 50%	120000
Total Sales	120000		Total Sales	120000
Sales	120000		Sales	120000
Variable Expense(50%)	60000		Variable Expense(75%)	90000
Income Before Interest	60000		Income Before Interest	30000
Interest(Fixed Expense)	90000		Interest(Fixed Expense)	30000
Net Income	-30000		Net Income	0

If sales decrease by 50%, Net loss of Ellis company is $30000 from $30000(Net Income) and Seidel Company reduces from $30000 to $0

To determine

Requirement 8:

To determine:

Changes If sales decrease by 40%

Explanation of Solution

Ellis Company			Seidel Company
Sales	240000		Sales	240000
Less 80%	192000		Less 50%	192000
Total Sales	48000		Total Sales	48000
Sales	48000		Sales	48000
Variable Expense(50%)	24000		Variable Expense(75%)	36000
Income Before Interest	24000		Income Before Interest	12000
Interest(Fixed Expense)	90000		Interest(Fixed Expense)	30000
Net Income	-66000		Net Income	-18000

If sales decrease by 80% net loss of Miller Company is $66000 from $30000 and Weaver Company suffers a loss of $18000 from profit of $30000.

To determine

Requirement 9:

To Understand:

The relation between fixed cost strategies and ratios calculated above for the two companies.

Explanation of Solution

Changes in Sales	Miller(% Change in Net Income)	Seidel(% Change in Net Income)
30%(Increase)	40	20
50%(Increase)	160	80
80%(Increase)	360	180
10%(Decrease)	80	40
20%(Decrease)	-100	0
40%(Decrease)	-220	-60

As can be observed in above table Miller is more sensitive to any changes made in sales, while Siedel is less sensitive.

The reason being that Miller has a lower percentage of variable expenses to sales and Siedel has a higher percentage of variable expense, also fixed expenses of Miller are higher than that of Seidel. Thus, any changes in sales lead to higher changes in Miller as compared to Seidel.

Also Miller due to its higher fixed costs have a lower “Times Interest Earned “ ratio as compared to Siedel.