Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 10 Liabilities 465

The quick ratio for both companies would be computed as shown:

Barnes & Noble, Inc.:

$535.7$74.6

0.46

$1,325.6

Borders, Inc.:

$244.8$95.4$118.3

0.38

$1,196.0

Both companies’ ratios are less than the “rule of thumb” guidelines. This is not sur-
prising, since retail bookselling companies, such as Barnes & Noble and Borders, are
not expected to have large accounts receivable balances. Most of their sales would be
cash and credit card; thus, they can satisfy current liabilities as sales are made, with-
out having to wait for collections.
In comparing the two companies, the current ratio is nearly identical, while
Barnes & Noble has a slightly larger quick ratio, indicating a slightly stronger quick
asset position.

Long-Term Liability Analysis

As an individual, if you have an annual salary of $50,000, you should not borrow
$500,000 for a new house. Your monthly income cannot support the monthly debt pay-
ments. Similarly, managers set long-term debt levels that can be supported by the com-
pany’s income. The ability of a business to meet its fixed financial obligations (debts)
is called leverage. We will describe two leverage ratios.

Number of Times Interest Charges Are Earned. The first leverage ratio measures
the relationship between a company’s income and its interest expense on debt. The
ratio is called the number of times interest charges are earnedduring the year (or
interest coverage ratio) and is calculated as follows:

Number of Times InterestIncome Before Income TaxInterest Expense

Charges Are Earned Interest Expense

The calculation uses “income before income tax” in the numerator, because the amount
available to make interest payments is not affected by taxes on income. This is because
interest is deductible in determining taxable income. In interpreting the ratio, the
higher the ratio, the higher the likelihood that interest payments will continue to be
made if earnings decrease. In contrast, the lower the ratio, the lower the likelihood the
company will be able to support its required interest payments from current period
earnings.
To illustrate this ratio, the following financial statement information was taken
from the fiscal 2004 annual reports for Barnes & Noble and Borders:

Barnes & Noble, Inc. Borders, Inc.

(in millions) (in millions)

Interest expense $ 14.5 $ 9.1

Income before taxes 218.6 207.6

The number of times interest charges are earned for Barnes & Noble and Borders is
16.1 and 23.8, respectively, calculated using the formula above as follows: