An analyst suspects that a particular company’s U.S. GAAP financial statements may require adjustment because the company uses take-or-pay contracts. The most likely effect of the appropriate adjustments would be to increase that company’s A. return on assets. B. debt-to-equity ratio. C. interest coverage ratio. D. return on common equity. It’s A right? is this question tricky?
B makes the most sense to me. With throughput arrangements you don’t record the debt obligation, so in order to accurately analyze f/s, you’d need to add back the PV of debt commitments, which would impact leverage ratios. I’d be curious to see what others think. edit: I didn’t mention that you’ll also need to add back PV of assets, so that would decrease ROA. I still think it’s B because once you add addiional debt, the debt-to-equity ratio will go up, which is what the question is asking. What is the answer?
I too thought it was B at first glance. CP
I got with B. Take-or-pay contracts are indirect obligations of the sponsor (it is disclosed in footnotes and not in balance sheet). Hence, D/E ratio would likely go up when adjuuting for such contracts. What’s the answer bigeasyt? Thanks.
It’s got to be B. The company will be obligated to pay some amount to its supplier whether or not it takes delivery of whatever asset is involved in the take-or-pay contract. So as lola pointed out, it’s much like a debt obligation. Note that increasing A, C or D would all be favorable to the company, and all require some measure of income to rise (net income for A or D, EBIT for C) by more than their denominators. So far as I can see, adjusting for a take-or-pay contract doesn’t involve increasing any of these earnings measures. Just my $0.02.
Hey guys we seem to be making a mistake with this question. I am just reading the book Page 228 in Schweser. Since the Debt in a take-or-pay contact is Off-the-balance-sheet, it has the effect of lowering the Debt ratio and the debt-to-equity ratio. A. return on assets.
cpk123, I think we’re all in agreement that leaving the take-or-pay contract off the B/S is consistent with GAAP and that this has the affects you’ve identified. However, I think this question is asking about how to treat the contract from an analytical perspective which often requires us to reclassify items from GAAP methodology. So, if for analytical reasons, we chose to treat the take-or-pay contract as debt and add it onto the B/S, it will increase the D/E ratio. Anyway, it’s late, my brain is officially punching out. I’ll wait to see what answer bigeasyt posts 
With take or pay, both the Asset side and Debt side of the B/S have to be adjusted by PV of the contracts.
It should be B. As hiredguns/highparkcfa noted, for analytical purposes, we would need to add PV of obligation to assets as well as debt. After the adjustment Debt increases so Debt to Equity ratio will also increase. A: As Assets are increasing, no impact on NI --> ROA goes down D: No impact on ROE as NI & Equity are unchanged C: No impact on EBIT, Iam not sure about interest?? Anybody?? Since it is a PV of obligation do we need to show its accretion as interest expense (just like an ARO).
It should be B. All the other choices are “beneficial” ratios, in which I mean an increase in them means more profitability. Increase in ROA, ROE, Interest Coverage…means more income/profitability. We are basically putting debt obligations back on the financial statements by adjusting them for take or pay contracts. Only an increase in B makes sense. Delhi, What is an ARO? Can’t remember that acronym…
asset retirement obligation
here’s an answer from my wicked smart friend. Hey Terry, Take or pay contracts usually result in a liability being created. The opposite side of the entry should be an asset (perhaps inventory) being increased. In that case, return on assets would go down. xxx , CFA, CPA Yale School of Management
But bigeasyt question is asking what would increase… not what would decrease. CP
bigeasyt Wrote: ------------------------------------------------------- > here’s an answer from my wicked smart friend. […] now that we’ve established what the ad verecundiam argument is, can we get the answer from wherever you got this question? where’s this question from anyway?
I’m glad im not wicked smart…or I would have got this question wrong.
delhirocks Wrote: ------------------------------------------------------- > It should be B. As hiredguns/highparkcfa noted, > for analytical purposes, we would need to add PV > of obligation to assets as well as debt. After the > adjustment Debt increases so Debt to Equity ratio > will also increase. > > A: As Assets are increasing, no impact on NI --> > ROA goes down > > D: No impact on ROE as NI & Equity are unchanged > > C: No impact on EBIT, Iam not sure about > interest?? Anybody?? Since it is a PV of > obligation do we need to show its accretion as > interest expense (just like an ARO). Even if it does impact interest, my guess is that it will increase interest, meaning that Interest Coverage would fall, not increase. I go with B also.
sorry guys. i dont know the answer. was hoping you guys would know.
I’d go with B!
As far as I know using take-or-pay contracts is a technique of off-balance sheet financing. The company is trying to get debt off their BS, to appear less risky in order to minimize cost of borrowing. As an analyst one would add back this debt which would subsequently increase the debt-to-equity ratio. Hope this helps…