PROBLEM 10–6 Your supervisor is considering purchasing the bonds and preferred shares of ARC Corp. She fur- 

nishes you the following ARC income statement and expresses concern about the coverage of fixed charges.

ARC CORPORATION Consolidated Income Statement For Year Ended December 31, Year 5 Sales ........................................................................................... $27,400 Income of less than 50%-owned affiliates (note 1) .................... 800 Total revenue............................................................................... 28,200 Cost of goods sold....................................................................... (14,000)

Gross profit............................................................................. 14,200 Selling and administrative expenses .......................................... $3,600 Depreciation (note 2) .................................................................. 1,200 Rental expenses (note 3)............................................................. 1,400 Share of minority interests in consolidated income (note 4) ....... 600 Interest expense (note 5)............................................................. 1,200 (8,000)

Income before income taxes........................................................ 6,200 Income taxes Current ................................................................................... $2,000 Deferred.................................................................................. 1,000 $ (3,000)

Net income .................................................................................. $ 3,200 Dividends Preferred stock........................................................................ 400 Common stock ........................................................................ 1,000 (1,400)

Increase in retained earnings...................................................... $ 1,800 Notes:
1. For the income from affiliates, $600 is undistributed.
2. Includes $80 amortization of previously capitalized interest.
3. Includes $400 of interest implicit in operating lease rental payments.
4. These subsidiaries do not have fixed charges.
5. Interest expense includes:
Interest incurred (except items below) ....... $ 880 Amortization of bond discount..................... 100 Interest portion of capitalized leases .......... 340 Interest capitalized ..................................... (120)
$1,200 6. The following changes occurred in current year balance sheet accounts:
Accounts receivable .................................... $(600)
Inventories .................................................. 160 Payables and accrued expenses.................. 120 Dividends payable....................................... (80)
Current portion of long-term debt ............... (100)
7. Tax rate is 40 percent.
Required:

a. Compute the following earnings coverage ratios:
(1) Earnings to fixed charges. (3) Earnings coverage of preferred dividends.
(2) Cash flow to fixed charges.

b. Analyze and interpret the earnings coverage ratios in (a).