Question

Discuss whether there are insolvency concerns for a company with high financial leverage and a high times interest earned ratio? What factor related to earnings could influence this association.

Answer 1

• High financial leverage is when company takes more debt to finance its assets. The company believes it will be able to generate higher rate of return on assets than the cost of capital to be paid by the organization. If the organization is not able to generate higher ROA then insolvency risk increases as debt payments are obligation on the organization.
• High times interest earned ratio shows the organization ability to pay its obligation. High times interest earned ratio reduces insolvency risks for the organization.

Company having both high leverage and high times interest earned ratios show the company is borrowing large debt to finance its assets but the company is able to generate higher return on assets as compared to cost of capital paid. Such organizations do not have insolvency risks but during recessions where the business growth is impacted or any adverse business situation insolvency risk increases.

Insolvency concerns are associated with earnings in below ways:

• Organization need to finance lot of capital expenditure on assets to generate revenues.
• Risks arising from lower expected earnings and interest payouts.