Question

SOF Antiques (SOF) reported the following comparative income figures in 2006.

	2006	2005
Net Sales	$701	$646
Other income	10	8
	$711	$654
Costs and expenses:
Cost of goods sold	$472	$408
Selling and general expenses	176	156
Interest	28	22
	$676	$586
Income before income taxes and extraordinary items	$35	$68
Income taxes	-15	-30
Income before extraordinary items	$20	$38
Extraordinary items- fire		$18
Net income	$20	$20

Your boss, the president of Alvarez Bank, is concerned about SOF's borrowing capacity. A representative of SOF feels that there should be no problem, since net profits are the same with slightly higher sales.

Required:

Compute times interest earned and comment on the bank's position.

Answer 1

SOLUTION

Times Interest Earned = Recurring Earnings Before Interest, Tax, Minority Income and Equity Earnings / Interest Expense, Including Capitalized Interest

	2006	2005
Income before income taxes and extraordinary items	35	68
Plus interest expense	28	22
Income (A)	63	90
Interest expense (B)	28	22
Times interest earned (A/B)	2.25 times	4.09 times

The ability of the firm to cover its interest has declined substantially due both to rising interest and falling income.

The statement by the SOF Antiques representative is false. The only reason that net income was at $20,000 in 2005 was because of the extraordinary fire loss. Recurring profits dropped from $38,000 to $20,000.