Question

4. Debt (or leverage) management ratios

Companies have the opportunity to use varying amounts of different sources of financing to acquire their assets, including internal and external sources, and debt (borrowed) and equity funds.

1. Which of the following is considered a financially leveraged firm?

a. A company that uses debt to finance some of its assets

b. A company that uses only equity to finance its assets

2. Which of the following is true about the leveraging effect?

a. Interest on debt is a tax deductible expense, which means that it can reduce a firm’s taxable income and tax obligation.

b. Interest on debt can be deducted from pre-tax income, resulting in a greater taxable income and a smaller available operating income.

Red Snail Satellite Company has a total asset turnover ratio of 3.50x, net annual sales of $25 million, and operating expenses of $11.25 million (including depreciation and amortization). On its current balance sheet and income statement, respectively, it reported total debt of $2.5 million, on which it pays 7% interest on its outstanding debt.

To analyze a company’s financial leverage situation, you need to measure the firm’s debt management ratios. Based on the preceding information, what are the values for Red Snail Satellite’s debt management ratios? (Note: Do not round intermediate calculations.)

RatioValueDebt ratioTimes-interest-earned ratio  

Red Snail Satellite Company raises around from creditors for each dollar of equity.

Influenced by a firm’s ability to make interest payments and pay back its debt, if all else is equal, creditors would prefer to give loans to companies with ____ (low or high) debt ratios.

Answer 1

1. Which of the following is considered a financially leveraged firm?

a. A company that uses debt to finance some of its assets

2. Which of the following is true about the leveraging effect?

a. Interest on debt is a tax deductible expense, which means that it can reduce a firm’s taxable income and tax obligation.

Red Snail Satellite Company has a total asset turnover ratio of 3.50x, net annual sales of $25 million, and operating expenses of $11.25 million (including depreciation and amortization). On its current balance sheet and income statement, respectively, it reported total debt of $2.5 million, on which it pays 7% interest on its outstanding debt.

Debt ratio = Total Debt / Total Assets

Debt ratio = 2.50 M / (Sales * Asset turnover Ratio)

Debt ratio = 2.50 M / (25 M/ 3.50)

Debt ratio = 35.00%

Time interest earned = (Sales - Operating Expenses - Interest) / Interest

Time interest earned = (25 M - 11.25 M ) / 2.50 M * 7%

Time interest earned = 13.75 M / 0.175

Time interest earned = 78.57 Times

Red Snail Satellite Company raises around $0.5385 (Debt ratio / EQuity ratio = 0.35 / 0.65) from creditors for each dollar of equity.

Influenced by a firm’s ability to make interest payments and pay back its debt, if all else is equal, creditors would prefer to give loans to companies with low debt ratios.