Question

Company ABC has a large, wholly owned consolidated finance subsidiary. For each of the following ratios, state the effect (higher, lower, or no effect) that consolidation has on the ratio of Company ABC compared to the ratio it would have if it accounted for its finance subsidiary using the equity method. Briefly explain why each effect occurs.  
a. Debt to equity ratio
b. Return on assets
c. Times interest earned

Answer 1

a) Debt Equity Ratio :

The Debt equity ratio indicates the proportionof the companies assets that are being financed through debt.

                  Debt Equity Ratio = Total Liabilities / Shareholders Equity

• High debt equity ratio generally means company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

If the ratio is increasing the company is being financed by creditors rather than from its own financial sources. Which may be dangerous trend

• Mostly lenders and investors prefer low debt equity ratio because their interests are better protected in the event of a business decline.
• Optimal debt equity ratio is considered to be about i.e. liabilities=eqity,but the ratio is very industry specific because it depends on proportion of current and non current assets.The more non current assets,the more equityis required to finance these long term investments.

b) RETURN OF ASSETS :

Companies use the return of assets ratio to determine whether they are earning enough money from capital investments. These investments might include things such as building facilities, land, machinery etc

            ROA = Net Income / Total Assets

• Low percentage return on assets indicates that the company is not making enough income from the use of its assets. In some cases a low percentage return may be acceptable. For instance,firm recently purchased an expencive piece of machinery for one of its manufacturing plants, the return on that asset mey be low for the first few years of operation

• Low percentage return on assets may indicate an inefficient use of company facilities, machinery or fleet. This is especially true if the return on assets percentage is lower than the industry average. For example, the company may own too many fleet vehicles that spend more time sitting in parking lots than hauling manufactured goods. Another possibility is that the fleet vehicles are outdated and cost too much to maintain. Long-term or capital leases that cost more per square foot than the company yields in sales per square foot is another example of an inefficient use of company assets.

• ROA over 5% are generally considered as good

c) TIMES INTEREST EARNED RATIO :

Times interest earned ratio is also called as Interest Coverage ratio. This is an indicator of the firms debt paying ability measuring the income that can be used for covering interest expenses in future.

    Times Interest Earned = Earnings before interest and taxes(EBIT) / Interest expenses

• As you can see ,creditors would favour a company with a much higher times interest ratio because it shows the company can afford to pay its interst payments when they come due,Higher ratios are less risky, While lower ratios indicate credit risk.