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How is the times-interest-earned ratio calculated, and what does it evaluate?

Short Answer

Expert verified

The times-interest-earned ratio is the ratio between earnings before interest & tax (EBIT) and interest expense.

Step by step solution

01

Times-interest-earned ratio

Times-interest-earned is a kind of ratio that evaluates a business’s ability to pay interest expenses. It is also called the interest coverage ratio. A high coverage ratio indicates the easiness to pay interest and a low ratio indicates difficulty.

02

Calculation and interpretation of the ratio

The interest coverage ratio is calculated by dividing the EBIT by the interest expense. EBIT is the earnings before making any deductions regarding interest and tax. So EBIT represents the amount that is available for disbursement of any interest expense. Tax liability arises after paying interest.

So, the times-interest ratio indicates the available earnings multiples of interest expense. It compares the earnings before interest and tax times of interest expense.

Times-interest-earned=EBITNetincome+Incometax+InterestInterestexpense

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Most popular questions from this chapter

Many small businesses have to squeeze down costs any way they can just to survive. One way many businesses do this is by hiring workers as “independent contractors” rather than as regular employees. Unlike rules for regular employees, a business does not have to pay Social Security (FICA) taxes and unemployment insurance payments for independent contractors. Similarly, it does not have to withhold federal, state, or local income taxes or the employee’s share of FICA taxes. The IRS has a “20-factor test” that determines whether a worker should be considered an employee or a contractor, but many businesses ignore those rules or interpret them loosely in their favor. When workers are treated as independent contractors, they do not get a W-2 form at tax time (they get a 1099 instead), they do not have any income taxes withheld, and they find themselves subject to “self-employment” taxes, by which they bear the brunt of both the employee’s and the employer’s shares of FICA taxes.

Requirements

  1. When a business abuses this issue, how is the independent contractor hurt?

If a business takes an aggressive position—that is, interprets the law in a very slanted way—is there an ethical issue involved? Who is hurt?

On January 1, Irving Company purchased equipment of \(280,000 with a long-term note payable. The debt is payable in annual installments of \)56,000 due on December 31 of each year. At the date of purchase, how will Irving Company report the note payable?

How might a business use a payroll register?

This problem continues the Canyon Canoe Company situation from Chapter 10. Amber and Zack Wilson are continuing their analysis of the company’s position and believe the company will need to borrow \(15,000 in order to expand operations. They consult Rivers Nation Bank and secure a 6%, one-year note on September 1, 2019, with interest due at maturity. Additionally, the company hires an employee, John Vance, on September 1. John will receive a salary of \)3,000 per month. Payroll deductions include federal income tax at 25%, OASDI at 6.2%, Medicare at 1.45%, and monthly health insurance premium of \(250. The company will incur matching FICA taxes, FUTA tax at 0.6%, and SUTA tax at 5.4%. Round calculations to two decimals. Omit explanations on journal entries.

Requirements

  1. Record the issuance of the \)15,000 note payable on September 1, 2019.
  2. Record the employee payroll and employer payroll tax entries on September 30, 2019.
  3. Record all payments related to September’s payroll. Payments are made on October 15, 2019.
  4. Record the entry to accrue interest due on the note at December 31, 2019.

Record the entry Canyon Canoe Company would make to record the payment to the bank on September 1, 2020.

Macintosh Company has monthly salaries of \(26,000. Assume Macintosh pays all the standard payroll taxes, no employees have reached the payroll tax limits, total income tax withheld is \)2,000, and the only payroll deductions are payroll taxes. Journalize the accrual of salaries expense, accrual of employer payroll taxes, and payment of employee and employer payroll taxes for Macintosh Company.

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