Principles of Financial Accounting: Long Term Liabilities - Bond Ratios, Debt to Equity Times Interest Earned

What It Is

Bond ratios are financial metrics used to assess a company's debt and equity positions. They help investors and creditors evaluate a company's ability to meet its debt obligations and generate cash flows. For example, if a company has $100,000 in total debt and $50,000 in total equity, its debt-to-equity ratio would be 2:1, indicating that it has twice as much debt as equity.

Key Concepts & Formulas

• Debt-to-Equity Ratio: A measure of a company's debt relative to its equity, calculated as Total Debt ÷ Total Equity. Example: A company has $100,000 in debt and $50,000 in equity, so its debt-to-equity ratio is 2:1.
• Times Interest Earned (TIE) Ratio: A measure of a company's ability to pay interest on its debt, calculated as Earnings Before Interest and Taxes (EBIT) ÷ Interest Expense. Example: A company has EBIT of $20,000 and interest expense of $5,000, so its TIE ratio is 4:1.
• Gross Profit: The difference between sales revenue and cost of goods sold (COGS), calculated as Sales Revenue – COGS. Example: A company has sales revenue of $100,000 and COGS of $60,000, so its gross profit is $40,000.
• Net Income: The profit earned by a company after deducting all expenses, calculated as Revenue – COGS – Operating Expenses – Interest Expense – Taxes. Example: A company has revenue of $100,000, COGS of $60,000, operating expenses of $20,000, interest expense of $5,000, and taxes of $10,000, so its net income is $5,000.
• Interest Coverage Ratio: A measure of a company's ability to pay interest on its debt, calculated as EBIT ÷ Interest Expense. Example: A company has EBIT of $20,000 and interest expense of $5,000, so its interest coverage ratio is 4:1.
• Current Ratio: A measure of a company's ability to pay its short-term debts, calculated as Current Assets ÷ Current Liabilities. Example: A company has current assets of $100,000 and current liabilities of $50,000, so its current ratio is 2:1.

Journal Entry Examples

1. Debt issuance: A company issues $10,000 in bonds payable. Dr. Bonds Payable $10,000 Cr. Cash $10,000 Explanation: The company receives cash from the bond issuance and records it as a liability.
2. Debt repayment: A company repays $5,000 of bonds payable. Dr. Cash $5,000 Cr. Bonds Payable $5,000 Explanation: The company pays off part of its debt and reduces the liability.
3. Interest expense: A company records interest expense on its bonds payable. Dr. Interest Expense $1,000 Cr. Bonds Payable $1,000 Explanation: The company records the interest expense as a liability.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts. Correction: Remember that debits increase assets and expenses, while credits increase liabilities and equity.
2. Mistake: Forgetting to record interest expense on debt. Correction: Always record interest expense as a liability, even if it's not a cash transaction.
3. Mistake: Not considering the time value of money when calculating bond ratios. Correction: Use present value calculations to account for the time value of money when calculating bond ratios.

Exam Tips

1. Tip: When calculating bond ratios, make sure to use the correct formula and units. Example: The debt-to-equity ratio is calculated as Total Debt ÷ Total Equity, not Total Debt ÷ Total Assets.
2. Tip: Be careful when reversing normal balances in journal entries. Example: If a company has a normal balance in the cash account, a debit will increase the balance, but a credit will decrease it.
3. Tip: Use the correct accounting equation to verify journal entries. Example: The accounting equation is Assets = Liabilities + Equity, so make sure journal entries balance the equation.

Quick Practice

1. What is the adjusting entry for accrued salaries of $5,000? Answer: Dr. Salaries Expense $5,000, Cr. Salaries Payable $5,000 Explanation: The company records the accrued salaries as an expense and a liability.
2. What is the journal entry for issuing $10,000 in bonds payable? Answer: Dr. Bonds Payable $10,000, Cr. Cash $10,000 Explanation: The company receives cash from the bond issuance and records it as a liability.
3. What is the debt-to-equity ratio for a company with $100,000 in debt and $50,000 in equity? Answer: 2:1 Explanation: The debt-to-equity ratio is calculated as Total Debt ÷ Total Equity.

Last-Minute Cram Sheet

1. Dividends are NOT an expense – they go directly to retained earnings.
2. Debt-to-equity ratio = Total Debt ÷ Total Equity.
3. Times Interest Earned (TIE) ratio = EBIT ÷ Interest Expense.
4. Gross profit = Sales Revenue – COGS.
5. Net income = Revenue – COGS – Operating Expenses – Interest Expense – Taxes.
6. Interest coverage ratio = EBIT ÷ Interest Expense.
7. Current ratio = Current Assets ÷ Current Liabilities.
8. Debits increase assets and expenses, while credits increase liabilities and equity.
9. Interest expense is recorded as a liability.
10. Use present value calculations to account for the time value of money when calculating bond ratios.