4. Debt (or leverage) management ratios

Companies have the opportunity to use varying amounts of different sources of financing, including internal and external sources, to acquire their assets, debt (borrowed) funds, and equity funds.

Which of the following is considered a financially leveraged firm?

A company that uses only equity to finance its assets

A company that uses debt to finance some of its assets

Which of the following is true about the leveraging effect?

Using leverage can generate shareholder wealth, but if a company fails to make the interest and principal payments on its debt, credit default can reduce shareholder wealth.

Using leverage reduces a firms potential for gains and losses.

Red Snail Satellite Company has a total asset turnover ratio of 8.50x, net annual sales of $25 million, and operating expenses of $11 million (including depreciation and amortization). On its balance sheet and income statement, respectively, it reported total debt of $2.50 million on which it pays a 7% interest rate.

To analyze a companys financial leverage situation, you need to measure the firms debt management ratios. Based on the preceding information, what are the values for Red Snail Satellites debt management ratios?

Ratio	Value
Debt ratio
Times-interest-earned ratio

Influenced by a firms ability to make interest payments and pay back its debt, if all else is equal, creditors would prefer to give loans to companies with debt ratios.

7. More on ratio analysis

Analysts and investors often use return on equity (ROE) to compare profitability of a company with other firms in the industry. ROE is considered a very important measure, and managers strive to make the companys ROE numbers look good.

If a firm takes steps that increase its expected future ROE, its stock price will increase.

Based on your understanding of the uses and limitations of ROE, which of the following projects should be chosen if they have the same risk and cost of capital?

Project X, with 35% ROE and a large investment, generating high expected cash flows

Project Y, with 40% ROE and a small investment, generating low expected cash flows

Suppose you are trying to decide whether to invest in a company that generates a high expected ROE, and you want to conduct further analysis on the companys performance. If you wanted to conduct a trend analysis, you would:

Compare the firms financial ratios with other firms in the industry for a particular year

Analyze the firms financial ratios over time

You decide also to conduct a qualitative analysis based on the factors summarized by the American Association of Individual Investors (AAII). According to your understanding, a company with less competition is considered to be risky than companies with multiple competitors.

The American Association of Individual Investors (AAII) has identified several qualitative factors that should also be considered when evaluating a companys likely future financial performance. Consider the scenario and indicate how you would expect the described event or situation to affect the described business organization.

Southern Supply Inc.

As a result of targeting by unethical product liability attorneys, Southern, a small manufacturer of a revolutionary crawfish steamer, currently has a multimillion-dollar class action lawsuit pending.

Although the steamer is completely reliable and safe, one person was injured as a result of using it inappropriately. Other purchasers have joined the lawsuit in an effort to collect free funds.

How would you expect this situation to affect the assessment of Southerns financial condition and performance?

Lawsuits guarantee free advertising and therefore should be guaranteed to increase the firms current and future sales and profits.

Being small, Southern may lack the financial resources and media-management expertise to successfully defend itself in the lawsuit and the media. This could jeopardize Southerns current and future sales and profits.

Although nonquantitative factors may be relevant to a companys financial evaluation in general terms, the details of this specific situation are not relevant to the firms financial condition or performance.