Question

The relationship between financial leverage and profitability???Pelican? Paper, Inc., and Timberland? Forest, Inc., are rivals in the manufacture of craft papers. Some financial statement values for each company follow. Use them in a ratio analysis that compares the?firms' financial leverage and profitability.

item	pelican paper inc	timberland forest, inc
total assets	10,300,000	10,300,000
total equity (all common)	9,100,000	4,800,000
total debt	1,200,000	5,500,000
annual interest	120,000	550,000
total sales	27,000,000	27,000,000
EBIT	6,750,000	6,750,000
earnings available for common stockholders	3,985,200	3,726,000

a. Calculate the following debt and coverage ratios for the two companies. Discuss their financial risk and ability to cover the costs in relation to each other.

?(1) Debt ratio

?(2) Times interest earned ratio

b. Calculate the following profitability ratios for the two companies. Discuss their profitability relative to each other.

?(1) Operating profit margin

?(2) Net profit margin

?(3) Return on total assets

?(4) Return on common equity

c. In what way has the larger debt of Timberland Forest made it more profitable than Pelican? Paper? What are the risks that? Timberland's investors undertake when they choose to purchase its stock instead of? Pelican's?

Answer 1

a).

1.Debt Ratio = Total Liabilities / Total Assets

Pelican Paper = 1,200,000 / 10,300,000 = 11.65%

Timberland Forest = 5,500,000 / 10,300,000 = 53.40%

2. Times Interest Earned Ratio = (EBIT) / Interest

Pelican Paper = 6,750,000 / 120,000 = 56.25

Timberland Forest = 6,750,000 / 550,000 = 12.27

Timberland Forest is a much greater financial risk than Pelican paper as indicated by the higher Debt Ratio and lower Times Interest Earned Ratios.

b).

1.Operating profit margin = Operating profits / Sales

Pelican Paper = 6,750,000 / 27,000,000 = 0.25

Timberland Forest = 6,750,000 / 27,000,000 = 0.25

2.Net profit margin = earnings available for common stockholders / Sales

Pelican Paper = 3,985,200 / 27,000,000 = 0.1476

Timberland Forest = 3,726,000 / 27,000,000 = 0.138

3.Return on total assets = Earnings available for common stockholders / Total Assets

Pelican Paper = 3,985,200 / 10,300,000 = 0.3869

Timberland Forest = 3,726,000 / 10,300,000 = 0.3617

4.Return on common equity = Earnings available for common stockholders / Common stock equity

Pelican Paper = 3,985,200 / 9,100,000 = 0.4379

Timberland Forest = 3,726,000 / 4,800,000 = 0.7763

Pelican paper is not as profitable as Timberland Forest.

c).

i) By financing, Timberland Forest has gained access to resources that allow for operating maneuverability.

ii) Timberland has less resources free to work with so if something unforeseen happens then company may not be able to compensate and the financiers will suffer.