Chapter 9, Problem 5PSB

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 Ellis Company.
2. Compute times interest earned for Seidel Company.
3. What happens to each company’s net income if sales increase by 10%?
4. What happens to each company’s net income if sales increase by 40%?
5. What happens to each company’s net income if sales increase by 90%?
6. What happens to each company’s net income if sales decrease by 20%?
7. What happens to each company’s net income if sales decrease by 50%?
8. What happens to each company’s net income if sales decrease by 80%?
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 times interest earned refer to the ratio of income before interest and taxes to interest earned.

To calculate: Times interest earned for company E.

Explanation of Solution

Computation of times interest earned for company E:

  $\begin{array}{c}\text{Times interest earned=}\frac{\text{Earning before Interest and Tax}}{\text{Interest Earned}}\\ =\frac{\$120,000}{\$90,000}\\ =1.3\text{times}\end{array}$

Summary Introduction

Introduction: The times interest earned refer to the ratio of income before interest and taxes to interest earned.

To calculate: Times interest earned for company S.

Explanation of Solution

Computation of times interest earned for company S:

  $\begin{array}{c}\text{Times interest earned=}\frac{\text{Earning before Interest and Tax}}{\text{Interest Earned}}\\ =\frac{\$60,000}{\$30,000}\\ =2\text{times}\end{array}$

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 10%.

Explanation of Solution

If sales increased by 10% for each company,

For company E;

  $\begin{array}{c}\text{Increase inSales = Sales}\times \frac{10}{100}\\ \text{= \$240,000 }\times \frac{10}{100}\\ =\$24,000\end{array}$

  $\begin{array}{c}\text{New sales = Old sales + Increase in sales}\\ =\$240,000+\$24,000\\ =\$264,000\end{array}$

For company S:

  $\begin{array}{c}\text{Increase inSales = Sales}\times \frac{10}{100}\\ \text{= \$240,000 }\times \frac{10}{100}\\ =\$24,000\end{array}$

  $\begin{array}{c}\text{New sales = Old sales + Increase in sales}\\ =\$240,000+\$24,000\\ =\$264,000\end{array}$

Computing net income for company E:

Particular	Amount
Sales	$264,000
Less: variable expense (50%)	(132,000)
Income before interest	132,000
Less: Interest expense(fixed)	(90,000)
Net income	$42,000

Computing net income for company S:

Particular	Amount
Sales	$264,000
Less: variable expense (75%)	(180,000)
Income before interest	84,000
Less: Interest expense(fixed)	(30,000)
Net income	$54,000

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 40%.

Explanation of Solution

If sales increased by 40% for each company,

For company E;

  $\begin{array}{c}\text{Increase in Sales = Sales }\times \frac{40}{100}\\ \text{= \$240,000 }\times \frac{40}{100}\\ =\$96,000\end{array}$

  $\begin{array}{c}\text{New sales}=\text{ Old sales + Increase in sales}\\ =\$240,000+\$96,000\\ =\$336,000\end{array}$

For company S:

  $\begin{array}{c}\text{Increase in Sales = Sales }\times \frac{40}{100}\\ \text{= \$240,000 }\times \frac{40}{100}\\ =\$96,000\end{array}$

  $\begin{array}{c}\text{New sales}=\text{ Old sales + Increase in sales}\\ =\$240,000+\$96,000\\ =\$336,000\end{array}$

Computing net income for company E:

Particular	Amount
Sales	$336,000
Less: variable expense (50%)	(168,000)
Income before interest	168,000
Less: Interest expense(fixed)	(90,000)
Net income	$78,000

Computing net income for company S:

Particular	Amount
Sales	$336,000
Less: variable expense (75%)	(252,000)
Income before interest	84,000
Less: Interest expense(fixed)	(30,000)
Net income	$54,000

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 90%.

Explanation of Solution

If sales increased by 90% for each company,

For company E;

  $\begin{array}{c}\text{Increase in sales = Sales }\times \frac{90}{100}\\ \text{= \$240,000 }\times \frac{90}{100}\\ =\$216,000\end{array}$

  $\begin{array}{c}\text{New sales= Old sales + Increase in sales}\\ =\$240,000+\$216,000\\ =\$456,000\end{array}$

For company S:

  $\begin{array}{c}\text{Increase in sales = Sales }\times \frac{90}{100}\\ \text{= \$240,000 }\times \frac{90}{100}\\ =\$216,000\end{array}$

  $\begin{array}{c}\text{New sales= Old sales + Increase in sales}\\ =\$240,000+\$216,000\\ =\$456,000\end{array}$

Computing net income for company E:

Particular	Amount
Sales	$456,000
Less: variable expense (50%)	(228,000)
Income before interest	228,000
Less: Interest expense(fixed)	(90,000)
Net income	$138,000

Computing net income for company S:

Particular	Amount
Sales	$456,000
Less: variable expense (75%)	(342,000)
Income before interest	114,000
Less: Interest expense(fixed)	(30,000)
Net income	$84,000

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 20%.

Explanation of Solution

If sales decreased by 20% for each company,

For company E;

  $\begin{array}{c}\text{Decrease in Sales = Sales }\times \frac{20}{100}\\ \text{= \$240,000 }\times \frac{20}{100}\\ =\$48,000\end{array}$

  $\begin{array}{c}\text{New sales = Old sales }-\text{ Decrease in sales}\\ =\$240,000-\$48,000\\ =\$192,000\end{array}$

For company S:

  $\begin{array}{c}\text{Decrease in Sales = Sales }\times \frac{20}{100}\\ \text{= \$240,000 }\times \frac{20}{100}\\ =\$48,000\end{array}$

  $\begin{array}{c}\text{New sales = Old sales }-\text{ Decrease in sales}\\ =\$240,000-\$48,000\\ =\$192,000\end{array}$

Computing net income for company E:

Particular	Amount
Sales	$192,000
Less: variable expense (50%)	(96,000)
Income before interest	96,000
Less: Interest expense(fixed)	(90,000)
Net income	$6,000

Computing net income for company W:

Particular	Amount
Sales	$192,000
Less: variable expense (75%)	(144,000)
Income before interest	48,000
Less: Interest expense(fixed)	(30,000)
Net income	$18,000

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 50%.

Explanation of Solution

If sales decreased by 50% for each company,

For company E;

  $\begin{array}{c}\text{Decrease in Sales = Sales }\times \frac{50}{100}\\ \text{= \$2,40,000 }\times \frac{50}{100}\\ =\$1,20,000\end{array}$

  $\begin{array}{c}\text{New sales}=\text{ Old sales }-\text{ Decrease in sales}\\ =\$240,000-\$120,000\\ =\$120,000\end{array}$

For company S:

  $\begin{array}{c}\text{Decrease in Sales = Sales }\times \frac{50}{100}\\ \text{= \$2,40,000 }\times \frac{50}{100}\\ =\$1,20,000\end{array}$

  $\begin{array}{c}\text{New sales}=\text{ Old sales }-\text{ Decrease in sales}\\ =\$240,000-\$120,000\\ =\$120,000\end{array}$

Computing net income for company E:

Particular	Amount
Sales	$120,000
Less: variable expense (50%)	(60,000)
Income before interest	60,000
Less: Interest expense(fixed)	(90,000)
Net income	($30,000)

Computing net income for company S:

Particular	Amount
Sales	$120,000
Less: variable expense (75%)	(90,000)
Income before interest	30,000
Less: Interest expense(fixed)	(30,000)
Net income	$0

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 80%.

Explanation of Solution

If sales decreased by 80% for each company,

For company E;

  $\begin{array}{c}\text{Sales = Sales }\times \frac{80}{100}\\ \text{= \$240,000 }\times \frac{80}{100}\\ =\$192,000\end{array}$

  $$

  $\begin{array}{c}\text{New sales}=\text{ Old sales }-\text{ Decrease in sales}\\ =\$240,000-\$192,000\\ =\$48,000\end{array}$

For company S:

  $\begin{array}{c}\text{Sales = Sales }\times \frac{80}{100}\\ \text{= \$240,000 }\times \frac{80}{100}\\ =\$192,000\end{array}$

  $\begin{array}{c}\text{New sales}=\text{ Old sales }-\text{ Decrease in sales}\\ =\$240,000-\$192,000\\ =\$48,000\end{array}$

Computing net income for company M:

Particular	Amount
Sales	$48,000
Less: variable expense (50%)	(24,000)
Income before interest	24,000
Less: Interest expense(fixed)	(90,000)
Net income	($74,000)

Computing net income for company W:

Particular	Amount
Sales	$48,000
Less: variable expense (75%)	(36,000)
Income before interest	12,000
Less: Interest expense(fixed)	(30,000)
Net loss	($18,000)

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:

For company E:

The time's interest earned by company E is 1.3 times which is lesser than 2.5 times this indicates that it is difficult for the company to meet its debt and to invest in the company is riskier from the investor's point of view.

For company S:

The time's interest earned by company E is 2times which lesser than 2.5 times but the situation is better than company S, 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 does not affect the net income as the sales increase but when sales start decreasing the net income is falling down and lead to losses for the company. Thus the company should increase sales or maintain sales to generate profit for the firm.