In: Accounting
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 $100 interest costs in the pension obligation during the year.
(d) “Company A has used financial leverage to increase its return to its shareholders”. Comment on this statement.
(a) Return on Assets = Net Income / Total Assets
Particulars | Company A ($) | 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.