Financial Accounting: An Integrated Statements Approach, 2nd Edition

Assume that The Gap Inc.has credit agreements that require a long-term liability to EBITDA

ratio that does not exceed 3 : 1. Financial requirements such as this are called loan or credit

covenants. The violation of a loan or credit covenant can result in the debt becoming due im-

mediately, as well as requirements to pay additional interest and penalties. The long-term

liabilities of The Gap Inc. at the end of 2005 and 2004 were $2,870 and $3,518 respectively.

1. Based upon your answer to Case 4-1, determine whether The Gap Inc. is in compliance with
   the loan covenant for 2005 and 2004. Round to one decimal place.


2. Assume that long-term debt does not change during 2006. Also, assume the following
   operating data for 2006:

Interest expense $200

Depreciation and amortization 650

Income before income taxes 300

Given this information, will The Gap Inc. violate its loan covenant in 2006? Show your com-

putations. Round to one decimal place.

3. Assuming that during 2006 the long-term debt does not change, how much would EBITDA
   have to decline before The Gap Inc. would violate the covenant?

The following income statement (in millions) is adapted from the 2004 10-K filing of Time

Warner:

Revenues $42,089

Cost of revenues 24,449

Gross profit $17,640

Selling, administrative, and other expenses 10,300

Amortization of goodwill and other intangible assets 626

Other costs and expenses 549

Operating income $ 6,165

Interest expense 1,754

Other nonrecurring income 651

Income before taxes $ 5,062

Income tax expense 1,698

Net income $ 3,364

Included in the preceding income statement is depreciation of property, plant, and equipment

of $6,132.

1. Compute the EBITDA for 2004.


2. Compute the percentage of EBITDA to total revenues for 2004. Round to one decimal place
   after converting to a percentage.


3. Compute the ratio of EBITDA to interest expense for 2004. Round to one decimal place.


4. Compute the ratio of long-term debt to EBITDA for 2004. The long-term debt as of December
   31, 2004, was $20,703. Round to one decimal place.


5. Comment on the ability of Time Warner to meet its interest obligations.

The following income statement (in thousands) is from the Securities and Exchange Commission

10-K filing by Amazon.comfor the year ending December 31, 2004:

204 Chapter 4 Accounting Information Systems

Case 4-3

Case 4-4

Case 4-2