Question

Evaluating Financial Performance Please respond to the following: Indicate the ratio(s) that is (are) best for evaluating the risk an entrepreneur is engaged in and indicate how each will direct decisions made in the business. Support your response.

Answer 1

1)A debt-to-equity ratio measures the amount of debt a company uses to fund its business for every dollar of equity it has. The ratio equals total liabilities divided by total stockholders’ equity, which are found on the balance sheet. The higher the ratio is, the more debt a business uses compared to equity. A ratio that is too high can potentially cause problems in your small business.

Increased Risk

The risk of defaulting on, or being unable to repay, your debt increases as your debt-to-equity ratio rises. A reasonable amount of debt can help you grow your small business, but too much can overburden you with high interest payments. You have to generate more business just to break even. If you fail to make these interest payments, creditors might take your company’s assets or force you into bankruptcy.

Trouble Obtaining Additional Financing

Banks typically require a low debt-to-equity ratio when they extend new credit. Because a high debt-to-equity ratio reduces a bank’s chances of being repaid, it might refuse to provide additional funding or might give you money only with unfavorable terms. Say your debt-to-equity ratio is 2 and the bank’s cutoff is 1.5; it would likely deny you a loan.

Violating Debt Covenants

Loan agreements often include covenants, which are stipulations that require a business to do or not do certain things, such as maintain adequate financial ratio levels. If your debt-to-equity ratio exceeds that allowed by a covenant with an existing lender, the lender might call your entire loan due. For example, if an existing lender requires you to keep your debt-to-equity ratio below 1.8 and it jumps to 2.1, you would violate the covenant.

2)

Interest Coverage Ratio

The interest coverage ratio is a basic measure of a company's ability to handle its short-term financing costs. The ratio value reveals the number of times that a company can make the required annual interest payments on its outstanding debt with its current earnings before taxes and interest. A relatively lower coverage ratio indicates a greater debt service burden on the company and a correspondingly higher risk of default or financial insolvency.

A lower ratio value means a lesser amount of earnings available to make financing payments, and it also means the company is less able to handle any increase in interest rates. Generally, an interest coverage ratio of 1.5 or lower is considered indicative of potential financial problems related to debt service. However, an excessively high ratio can indicate the company is failing to take advantage of its available financial leverage.

3)

Degree of Combined Leverage

The degree of combined leverage provides a more complete assessment of a company's total risk by factoring in both operating leverage and financial leverage. This leverage ratio estimates the combined effect of both business risk and financial risk on the company's earnings per share (EPS) given a particular increase or decrease in sales. Calculating this ratio can help management identify the best possible levels and combination of financial and operational leverage for the firm.