Question

11a. Explain the importance of the times-interest earned ratio when evaluating the potential for financial distress in a company. (page 505 and critical thinking)

11b. Describe NUCOR's financial risk compared to its industry based on ratios found in Table 14.5. (page 505)

11c. Describe Ford Motor Company's financial risk compared to its industry based on ratios found in Table 14.5. (page 505 and critical thinking)

As might be expected, wide variations in the use of financial leverage occur across industries and among the individual firms in each industry. Table 14.5 illustrates differences for selected companies in different industries, the ranking is in ascending order of the company’s long-term debt ratio.36 Petroleum, biotechnology, and steel companies use relatively little debt because their industries tend to be cyclical, oriented toward research, or subject to huge product liability suits. On the other hand, grocery stores, utility companies, and airlines use debt relatively heavily because their fixed assets make good security for mortgage bonds and their relatively stable sales make it safe to carry more than average debt. The TIE ratio gives an indication of how vulnerable the company is to financial distress. This ratio depends on three factors: (1) the percentage of debt, (2) the interest rate on the debt, and (3) the company’s profitability. Generally, low-leveraged companies such as Alphabet Inc. and Eli Lilly have high coverage ratios, whereas companies like Southern Company and Kroger, which have financed heavily with debt, have lower coverage ratios. Wide variations in capital structures also exist among firms in given industries. This can be seen from Table 14.5. For example, although the average ratio of long-term debt to total capital in 2017 for the aerospace industry was 55.36%, Rockwell Collins had a ratio of 36.31%. Thus, factors unique to individual firms,

Answer 1

Q. Explain the importance of the times-interest earned ratio when evaluating the potential for financial distress in a company.

Answer. The Times Interest Earned Ratio is of utmost importance while evaluating the potential for financial distress in a company as it helps in quantifying a company's probability of defaulting on the debt issued. o

The ratio is calculated by dividing EBIT/ Periodic interest expense to find out the number of times a company could pay its interest expense should all the EBIT be designated in making interest and debt repayments.

A high ratio indicates a safe position but a low ratio triggers financial distress in a company and this indication should be used to make a further analysis of other ratios to ensure financial distress infact exists in the company.

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