Question

Question: Shown here are condensed income statements for two different companies (both are organized as LLCs and pay no income taxes).

Sales . \(240,000

Variable expenses (50%) . 120,000

Income before interest 120,000

Interest expense (fixed) . 90,000

Net income . \) 30,000

Seidel Company

Sales . \(240,000

Variable expenses (75%) . 180,000

Income before interest 60,000

Interest expense (fixed) . 30,000

Net income . \) 30,000

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.

Short answer

Answer

The time’s interest ratio of the Ellis Company is1.33 times.

The time’s interest ratio of the Seidel Company is2 times.

	Ellis Company	Seidel Company
If sales are increased by 10%	Net income increased by 40%	Net income increased by 20%
If sales are increased by 40%	Net income increased by 160%	Net income increased by 80%
If sales are increased by 90%	Net income increased by 360%	Net income increased by 180%
If sales are decreased by 20%	Net income decreased by 80%	Net income decreased by 40%
If sales are decreased by 50%	Net income decreased by 200%	Net income decreased by 100%
If sales are decreased by 80%	Net income decreased by 320%	Net income decreased by 160%

Step-by-step solution

Meaning of Variable Cost

Variable costs refer to the cost that depends upon the activity level and changes according to the activity level.

Times interest earned of Ellis Company

$$\begin{gathered} \mathbf{\text{Times\hspace{0.05em}\hspace{0.05em}Interest\hspace{0.05em}\hspace{0.05em}Earned=\hspace{0.05em}}}\frac{\mathbf{I}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}\mathbf{ }\mathbf{ }\mathbf{b}\mathbf{e}\mathbf{f}\mathbf{o}\mathbf{r}\mathbf{e}\mathbf{ }\mathbf{ }\mathbf{i}\mathbf{n}\mathbf{t}\mathbf{e}\mathbf{r}\mathbf{e}\mathbf{s}\mathbf{t}\mathbf{\&}\mathbf{ }\mathbf{t}\mathbf{a}\mathbf{x}}{\mathbf{I}\mathbf{n}\mathbf{t}\mathbf{e}\mathbf{r}\mathbf{e}\mathbf{s}\mathbf{t}\mathbf{ }\mathbf{ }\mathbf{e}\mathbf{x}\mathbf{p}\mathbf{e}\mathbf{n}\mathbf{s}\mathbf{e}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\mathbf{\$}\mathbf{120}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{90}\mathbf{,}\mathbf{000}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{ }\mathbf{1}\mathbf{.}\mathbf{33}\mathbf{ }\mathbf{ }\mathit{t}\mathit{i}\mathit{m}\mathit{e}\mathit{s} \end{gathered}$$

Times interest earned of Seidel Company

$$\begin{gathered} \mathbf{\text{Times\hspace{0.05em}\hspace{0.05em}Interest\hspace{0.05em}\hspace{0.05em}Earned=\hspace{0.05em}}}\frac{\mathbf{Income}\mathbf{ }\mathbf{ }\mathbf{before}\mathbf{ }\mathbf{ }\mathbf{interest}\mathbf{\&}\mathbf{ }\mathbf{tax}}{\mathbf{Interest}\mathbf{ }\mathbf{ }\mathbf{expense}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\mathbf{\$}\mathbf{60}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{30}\mathbf{,}\mathbf{000}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{ }\mathbf{2}\mathbf{ }\mathbf{ }\mathit{t}\mathit{i}\mathit{m}\mathit{e}\mathit{s} \end{gathered}$$

Effect on net income if the sale is increased by 10%

Particulars	Ellis Company	Seidel Company
Sales ($240,00 x 110%)	$264,000	$264,000
Less: Variable expense (50%) and (75%)	$132,000	$198,000
Income before interest	$132,000	$66,000
Interest Expense (fixed)	$90,000	$30,000
Net income	$42,000	$36,000

Hence, if the sales are increased by 10%, the Ellis Company’s net income is increased by 40%, and the Seidel Company’s net income is increased by 20%.

Effect on net income if the sale is increased by 40%

Particulars	Ellis Company	Seidel Company
Sales ($240,00 x 140%)	$336,000	$336,000
Less: Variable expense (50%) and (75%)	$168,000	$252,000
Income before interest	$168,000	$84,000
Interest Expense (fixed)	$90,000	$30,000
Net income	$78,000	$54,000

Hence, if the sales are increased by 40%, the Ellis Company’s net income is increased by 160%, and the Seidel Company’s net income is increased by 80%.

Effect on net income if the sale is increased by 90%

Particulars	Ellis Company	Seidel Company
Sales ($240,00 x 190%)	$456,000	$456,000
Less: Variable expense (50%) and (75%)	$228,000	$342,000
Income before interest	$228,000	$114,000
Interest Expense (fixed)	$90,000	$30,000
Net income	$138,000	$84,000

Hence, if the sales are increased by 90%, the Ellis Company’s net income is increased by 360%, and the Seidel Company’s net income is increased by 180%.

Effect on net income if the sale is decreased by 20%

Particulars	Ellis Company	Seidel Company
Sales ($240,00 x 80%)	$192,000	$192,000
Less: Variable expense (50%) and (75%)	$96,000	$144,000
Income before interest	$96,000	$48,000
Interest Expense (fixed)	$90,000	$30,000
Net income	$6,000	$18,000

Hence, if the sales are decreased by 20%, the Ellis Company’s net income is decreased by 80%, and the Seidel Company’s net income is decreased by 40%.

Effect on net income if the sale is decreased by 50%

Particulars	Ellis Company	Seidel Company
Sales ($240,00 x 50%)	$120,000	$120,000
Less: Variable expense (50%) and (75%)	$60,000	$90,000
Income before interest	$60,000	$30,000
Interest Expense (fixed)	$90,000	$30,000
Net income	($30,000)	$0

Hence, if the sales are decreased by 50%, the Ellis Company’s net income is decreased by 200%, and the Seidel Company’s net income is decreased by 100%.

Effect on net income if the sale is decreased by 80%

Particulars	Ellis Company	Seidel Company
Sales ($240,00 x 20%)	$48,000	$48,000
Less: Variable expense (50%) and (75%)	$24,000	$36,000
Income before interest	$24,000	$12,000
Interest Expense (fixed)	$90,000	$30,000
Net income	($66,000)	($18,000)

Hence, if the sales are decreased by 80%, the Ellis Company’s net income is decreased by 320%, and the Seidel Company’s net income is decreased by 160%.

Relation between the strategies of both companies

The strategies of both companies related to the fixed cost are not good because the percentage of the variable expense is very high, which is not good for both companies.

The time’s interest earned ratio of Seidel Company is better than the Ellis company.