Question

Question: Review the chapter’s opening feature about Marcela Sapone and Jessica Beck and the business they founded, Hello Alfred. Assume that they are considering expanding the business to Europe and that the current abbreviated income statement appears as follows.

HELLO ALFRED Income Statement For Year Ended December 31, 2017
Sales	\(1,000,000
Operating expenses (55%)	550,000
Net income	450,000

Assume also that Hello Alfred currently has no interest-bearing debt. If it expands to Europe, it will require a \)300,000 loan. Hello Alfred has found a bank that will loan it the money on a 7% note payable. The company believes that, at least for the first few years, sales in Europe will equal \(250,000 and that all expenses at both locations will continue to equal 55% of sales.

Required

1. Prepare an income statement (showing three separate columns for current operations, European, and total) for the company assuming that it borrows the funds and expands to Europe. Annual revenues for current operations are expected to remain at \)1,000,000.

2. Compute the company’s times interest earned under the expansion assumptions in part 1.

3. Assume sales in Europe are \(400,000. Prepare an income statement (with columns for current operations, European, and total) for the company and compute times interest earned.

4. Assume sales in Europe are \)100,000. Prepare an income statement (with columns for current operations, European, and total) for the company and compute times interest earned.

5. Comment on your results from parts 1 through 4.

Short answer

Answer

1. The business entity will generate total net income of$541,500.
2. Times interest earned ratio of the company is26.78 times.
3. Times interest earned ratio of the company is30 timeswhen the sales for Europe is $400,000.
4. Times interest earned ratio of the company is23.57 timeswhen the sales for Europe is $100,000.
5. The business entity is able to cover its debt obligations at all level of estimated sales.

Step-by-step solution

Definition of Times Interest Earned

The financial metric that determines the ability of the company to meet the financial obligations such as interest payment with use of its current income is known as times interest earned.

Preparation of income statement using separate columns

Particular	Current operation	European	Total
Sales	$1,000,000	$250,000	$1,250,000
Less: Operating expenses (55% of sales)	(550,000)	(137,500)	(687,500)
Operating income	$450,000	$112,500	$562,500
Less: Interest expenses	(0)	(21,000)	(21,000)
Net income	$450,000	$91,500	$541,500

Working note:

1. European segment will report interest expenses of $21,000 (7% of $300,000).

Times interest earned ratio

$$\begin{gathered} Timesinterestearned=\frac{Earningsbeforeinterestandtax/Operatingincome}{Interestexpenses} \\ =\frac{\$562,500}{\$21,000} \\ =26.78times \end{gathered}$$

Income statement when sales in Europe are $400,000

Particular	Current operation	European	Total
Sales	$1,000,000	$400,000	$1,400,000
Less: Operating expenses (55% of sales)	(550,000)	(220,000)	(770,000)
Operating income	$450,000	$180,000	$630,000
Less: Interest expenses	(0)	(21,000)	(21,000)
Net income	$450,000	$159,000	$609,000

$$\begin{gathered} \text{Timesinterestearned=}\frac{Earningsbeforeinterestandtax/Operatingincome}{Interestexpenses} \\ =\frac{\$630,000}{\$21,000} \\ =30times \end{gathered}$$

Income statement when sales in Europe are $100,000

Particular	Current operation	European	Total
Sales	$1,000,000	$100,000	$1,100,000
Less: Operating expenses (55% of sales)	(550,000)	(55,000)	(605,000)
Operating income	$450,000	$45,000	$495,000
Less: Interest expenses	(0)	(21,000)	(21,000)
Net income	$450,000	$24,000	$474,000

$$\begin{gathered} \text{Timesinterestearned=}\frac{Earningsbeforeinterestandtax/Operatingincome}{Interestexpenses} \\ =\frac{\$495,000}{\$21,000} \\ =23.57times \end{gathered}$$

Interpretation of results

Even at worst sales level the times interest earned ratio is 23.57 times which means that the business entity is able to cover its debt obligation efficiently. And the business entity is generating positive income at every level of sales which means that the business entity is operating efficiently.