Debt (Or Leverage) Management Ratios

4.
Debt (or leverage) management ratios
Companies have the opportunity to use varying amounts of different sources of financing to acquire
their assets, including internal and external sources, and debt (borrowed) and equity funds.
Which of the following is considered a financially leveraged firm?
A company that uses debt to finance some of its assets
A company that uses only equity to finance its assets

Points:
1/1
Close Explanation
Explanation:
Companies that function without the use of borrowed money are said to have no leverage and are
called unleveraged companies. Unleveraged companies are financed by equity alone and have no debt
in their capital structures. Unleveraged firms are less risky, but they might also lose out on the
opportunities that they could otherwise pursue if they used borrowed money.
Companies that use debt funding are called leveraged companies, and are riskier than unleveraged
firms. Leverage allows a company to take advantage of investment opportunities that it could
otherwise not afford. Borrowed money could be used to expand more quickly and to capture market
share faster than if its business growth was financed solely with equity financing.
Which of the following is true about the leveraging effect?
Interest on debt is a tax deductible expense, which means that it can reduce a firm’s taxable
income and tax obligation.
Interest on debt can be deducted from pre-tax income, resulting in a greater taxable income and
a smaller available operating income.

Points:
1/1
Close Explanation
Explanation:
When a firm takes on debt, it has to make interest payments on that borrowed financing. Its interest
expense is deducted from the company’s pre-tax earnings (or earnings before interest and taxes,
EBIT). This leads to a lower taxable income, and tax obligation.
Red Snail Satellite Company has a total asset turnover ratio of 3.50x, net annual sales of $25 million,
and operating expenses of $11.25 million (including depreciation and amortization). On its current
balance sheet and income statement, respectively, it reported total debt of $2.5 million, on which it
pays 7% interest on its outstanding debt.
To analyze a company’s financial leverage situation, you need to measure the firm’s debt management
ratios. Based on the preceding information, what are the values for Red Snail Satellite’s debt
management ratios? (Note: Do not round intermediate calculations.)
Ratio Value
Debt ratio
35.00%
Times-interest-earned ratio
78.57x
Points:
1/1
Close Explanation
Explanation:
To find the value of the debt management ratio, first find out how much Red Snail Satellite Company
has in total assets. You know that Red Snail Satellite Company’s total assets turnover is 3.50 times.
Using this information, find the total assets that the company owns. Solve as follows:
Total Asset Turnover = Sales / Total Assets

Ratio
3.50 times = $25 million / Total Assets
Total Assets = $25 million / 3.50
= $7.142857 million
Now, use Red Snail Satellite Company’s total debt and total assets (which are financed by the sum of
the firm’s financial capital) to calculate its debt ratio, using the following formula:
Debt Ratio = Total Debt / Total Assets

= Total Debt / Total Debt & Equity
Solve as follows:
Debt Ratio = $2.5 million / $7.142857 million

= 35.000001%
To calculate the times-interest-earned (TIE) ratio, you need to know the firm’s operating income
(earnings before interest and taxes, or EBIT) and its annual interest expense. You are given neither,
but you can infer them from the given data.

First, find the operating income. Red Snail Satellite Company has annual sales of $25 million and total
expenses (or costs), including depreciation and amortization, of $11.25 million. Therefore, the EBIT
will be:
EBIT = Total Sales – Total Operating Costs

= $25 million – $ 11.25 million
= $13.750000 million
Interest Charges = Interest Rate x Debt Outstanding
= 7% x $2.5 million
= $0.175000 million
Use the EBIT and interest charges to solve for the TIE ratio, using the following formula:
TIE = EBIT / Interest Charges

Ratio
Solve as follows:
TIE Ratio = $13.750000 million / $0.175000 million

= 78.57x
Red Snail Satellite Company raises around 0.54 from creditors for each dollar of equity.
Points:
1/1
Close Explanation
Explanation:
The debt-to-equity ratio gives an indication of how much money a firm borrows for each dollar of
investment made by stockholders. You can calculate the debt-to-equity ratio using the following
formula:
Debt-to-Equity = Total Debt / Total Equity

Ratio
You know from debt ratio calculations that the firm has $2.5 million debt and total assets worth
$7.142857 million. Total assets comprise both debt and equity. Thus, total equity is $4.642857 million
($7.142857 million – $2.5 million). Solve for the debt-to-equity ratio as follows:
Debt-to-Equity = $2.5 million / $4.642857 million

Ratio
= 0.54
Red Snail Satellite’s debt-to-equity ratio is 0.54. This means that the company raises around $0.54
from its creditors for each dollar invested by its stockholders.
Influenced by a firm’s ability to make interest payments and pay back its debt, if all else is equal,
creditors would prefer to give loans to companies with low debt ratios.
Points:
1/1
Close Explanation
Explanation:
A high debt ratio would mean that the firm has taken on a lot of debt to finance its assets, making it
difficult for it to take on more debt. With more and more debt, a company may not be able to pay the
interest and the principal. To avoid this potential problem, creditors prefer to give loans to companies
that have low debt ratios.

Debt (Or Leverage) Management Ratios

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4.

Debt (or leverage) management ratios

Which of the following is considered a financially leveraged firm?

A company that uses debt to finance some of its assets

A company that uses only equity to finance its assets

Which of the following is true about the leveraging effect?

income and tax obligation.

a smaller available operating income.

EBIT). This leads to a lower taxable income, and tax obligation.

pays 7% interest on its outstanding debt.

management ratios? (Note: Do not round intermediate calculations.)

Total Asset Turnover = Sales / Total Assets

Debt Ratio = Total Debt / Total Assets

Debt Ratio = $2.5 million / $7.142857 million

but you can infer them from the given data.

EBIT = Total Sales – Total Operating Costs

TIE = EBIT / Interest Charges

TIE Ratio = $13.750000 million / $0.175000 million

Debt-to-Equity = Total Debt / Total Equity

Debt-to-Equity = $2.5 million / $4.642857 million

from its creditors for each dollar invested by its stockholders.

that have low debt ratios.

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