0.12x525,000= 3,000
Net profits before taxes
512,000
$ 9,000
Less: Taxes (rate = 40%)
4,800
3,600
(2) Net profits after taxes
$ 7,200
$ 5,400
Return on equity [(2) (1)]
$7,200
$5,400
- ' „„ = 14.4% $50,000 =
,.„ ' „ = 21.6% $25,000 =
tax profits of $7,200, which represent a 14.4% rate of return on Patty's $50,000 investment. The debt plan results in $5,400 of after-tax profits, which represent a 21.6% rate of return on Patty's investment of $25,000. The debt plan provides Patty with a higher rate of return, but the risk of this plan is also greater because the annual $3,000 of interest must be paid before receipt of earnings.
degree of indebtedness Measures the amount of debt relative to other significant balance sheet amounts.
ability to service debts The ability of a firm to make the payments required on a scheduled basis over the life of a debt coverage ratios
Ratios that measure the firm's ability to pay certain fixed charges.
The example demonstrates that with increased debt comes greater risk as well as higher potential return. Therefore, the greater the financial leverage, the greater the potential risk and return. A detailed discussion of the impact of debt on the firm's risk, return, and value is included in Chapter 12. Here, we emphasize the use of financial debt ratios to assess externally a firm's debt position.
There are two general types of debt measures: measures of the degree of indebtedness and measures of the ability to service debts. The degree of indebtedness measures the amount of debt relative to other significant balance sheet amounts. A popular measure of the degree of indebtedness is the debt ratio.
The second type of debt measure, the ability to service debts, reflects a firm's ability to make the payments required on a scheduled basis over the life of a debt.12 The firm's ability to pay certain fixed charges is measured using coverage ratios. Typically, higher coverage ratios are preferred, but too high a ratio (above industry norms) may result in unnecessarily low risk and return. In general, the
12. The term service refers to the payment of interest and repayment of principal associated with a firm's debt obligations. When a firm services its debts, it pays—or fulfills—these obligations.
lower the firm's coverage ratios, the less certain it is to be able to pay fixed obligations. If a firm is unable to pay these obligations, its creditors may seek immediate repayment, which in most instances would force a firm into bankruptcy. Two popular coverage ratios are the times interest earned ratio and the fixed-payment coverage ratio.13
debt ratio
Measures the proportion of total assets financed by the firm's creditors.
The debt ratio measures the proportion of total assets financed by the firm's creditors. The higher this ratio, the greater the amount of other people's money being used to generate profits. The ratio is calculated as follows:
Debt ratio =
Total liabilities Total assets
The debt ratio for Bartlett Company in 2009 is $1,643,000
$3,597,000
This value indicates that the company has financed close to half of its assets with debt. The higher this ratio, the greater the firm's degree of indebtedness and the more financial leverage it has.
Times Interest Earned Ratio times interest earned ratio Measures the firm's ability to make contractual interest payments; sometimes called the interest coverage ratio.
The times interest earned ratio, sometimes called the interest coverage ratio, measures the firm's ability to make contractual interest payments. The higher its value, the better able the firm is to fulfill its interest obligations. The times interest earned ratio is calculated as follows:
Times interest earned ratio =
The figure for earnings before interest and taxes is the same as that for operating profits shown in the income statement. Applying this ratio to Bartlett Company yields the following 2009 value:
Times interest earned ratio =
The times interest earned ratio for Bartlett Company seems acceptable. A value of at least 3.0—and preferably closer to 5.0—is often suggested. The firm's earnings before interest and taxes could shrink by as much as 78 percent [(4.5 —1.0) 4.5], and the firm would still be able to pay the $93,000 in interest it owes. Thus it has a good margin of safety.
13. Coverage ratios use data that are derived on a a accrual basis (discussed in Chapter 1) to measure what in a strict sense should be measured on a cash basis. This occurs because debts arc serviced by using cash flows, not the accounting values shown on the firm's financial statements. But because it is difficult to determine cash flows available for debt service from the firm's financial statements, the calculadon of coverage ratios as presented here is quite common thanks to the ready availability of financial statement data.
fixed-payment coverage ratio
Measures the firm's ability to meet all fixed-payment obligations.
The fixed-payment coverage ratio measures the firm's ability to meet all fixed-payment obligations, such as loan interest and principal, lease payments, and preferred stock dividends.14 As is true of the times interest earned ratio, the higher this value, the better. The formula for the fixed-payment coverage ratio is
Fixed-payment coverage ratio
Earnings before interest and taxes + Lease payments Interest 4- Lease payments +{(Principal payments + Preferred stock dividends) X [1/(1 - 7)]}
where Tis the corporate tax rate applicable to the firm's income. The term l/( 1 — T) is included to adjust the after-tax principal and preferred stock dividend payments back to a before-tax equivalent that is consistent with the before-tax values of all other terms. Applying the formula to Bartiett Company's 2009 data yields
coverage ratio ~ $93,000 + $35,000 4- {($71,000 4- $10,000) X [1/(1 - 0.29)]}
$453,000
$242,000
Because the earnings available are nearly twice as large as its fixed-payment obligations, the firm appears safely able to meet the latter.
Like the times interest earned ratio, the fixed-payment coverage ratio measures risk. The lower the ratio, the greater the risk to both lenders and owners; the greater the ratio, the lower the risk. This ratio allows interested parties to assess the firm's ability to meet additional fixed-payment obligations without being driven into bankruptcy.
REVIEW QUESTIONS 2—11 What is financial leverage?
2—12 What ratio measures the firm's degree of indebtedness"! What ratios assess the firm's ability to service debts?
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