Question

Below is information for the year 2019 for Company A and Company B.

Interest expense $400 $0

Tax expense (40%) $400 $400

Net income $600 $600

Ending balance of total asset $10,000 $10,000

Total debt $5,000 $0

Equity $5,000 $10,000

Required: Compute the following for Year 2019

(a) Return on assets for Company A and B

(b) Financial leverage ratio for Company A and B

(c) Times interest earned ratio, after necessary adjustments for Company A if it capitalized $100 interest costs in the pension obligation during the year.

(d) “Company A has used financial leverage to increase its return to its shareholders”. Comment on this statement.

Answer 1

(a) Return on Assets = Net Income / Total Assets

Particulars	Company A ($)	Company B ($)
1. Net Income	600	600
2. Total Assets	10,000	10,000
3. Return on Net Assets (1/2)*100	6	6%

(b) Financial Leverage Ratio = Total Debt / Shareholders Equity

Particulars	Company A ($)	Company B ($)
1. Total Debt	5,000	0
2. Total Equity	5,000	10,000
3. Financial Leverage (1/2)	1:1	0:10,000

(c) Times Interest Earned Ratio = (Net Income + Interest + Tax Expense) / Interest

Interest includes capitalised interest.

= (600+400+100+400) / (400+100)

= 1,500 / 500

= 3 times

(d) Financial Leverage refers to the extent of debt used in the capitalization of the company. Capital can be raised through Equity or Debt. Equity holders expect growth in the company and a long term return on their investment while debt holders expect a fixed sum of payment, namely the interest at the end of every period. At an ideal level of financial leverage, the company's return on equity increases. This is because interest is a tax saving expense while the return on equity is not. Let us consider the following 2 circumstances for better understanding of this concept:

Particulars	Company A - Present	Company B - Entirely financed by Equity
1. Total Assets	10,000	10,000
2. Debt	5,000	0
3. Equity (1-2)	5,000	10,000

Total Income of Company A = Net Income + Tax Expense + Interest

= 600 + 400 + 400 = 1,400

Particulars	Company A - Present	Company B - Entirely financed by Equity
1. Total Income	1,400	1,400
2. Less: Interest Expense	(400)	-
3. Earnings Before Tax (EBT)	1,000	1,400
4. Less: Tax Expense @ 40% on EBT	(400)	(560)
5. Net Income	600	840
6. Equity	5,000	10,000
7. Return on Equity (5/6)*100	12%	8.4%

Hence, the above calculation proves that A has used financial leverage to increase its return to its shareholders.