The relationship between financial leverage and profitability ???Pelican? Paper,
ID: 2616037 • Letter: T
Question
The relationship between financial leverage and profitability???Pelican? Paper, Inc., and Timberland? Forest, Inc., are rivals in the manufacture of craft papers. Some financial statement values for each company follow. Use them in a ratio analysis that compares the?firms' financial leverage and profitability.
total assets
a. Calculate the following debt and coverage ratios for the two companies. Discuss their financial risk and ability to cover the costs in relation to each other.
?(1) Debt ratio
?(2) Times interest earned ratio
b. Calculate the following profitability ratios for the two companies. Discuss their profitability relative to each other.
?(1) Operating profit margin
?(2) Net profit margin
?(3) Return on total assets
?(4) Return on common equity
c. In what way has the larger debt of Timberland Forest made it more profitable than Pelican? Paper? What are the risks that? Timberland's investors undertake when they choose to purchase its stock instead of? Pelican's?
item pelican paper inc timberland forest, inctotal assets
10,300,000 10,300,000 total equity (all common) 9,100,000 4,800,000 total debt 1,200,000 5,500,000 annual interest 120,000 550,000 total sales 27,000,000 27,000,000 EBIT 6,750,000 6,750,000 earnings available for common stockholders 3,985,200 3,726,000Explanation / Answer
a).
1.Debt Ratio = Total Liabilities / Total Assets
Pelican Paper = 1,200,000 / 10,300,000 = 11.65%
Timberland Forest = 5,500,000 / 10,300,000 = 53.40%
2. Times Interest Earned Ratio = (EBIT) / Interest
Pelican Paper = 6,750,000 / 120,000 = 56.25
Timberland Forest = 6,750,000 / 550,000 = 12.27
Timberland Forest is a much greater financial risk than Pelican paper as indicated by the higher Debt Ratio and lower Times Interest Earned Ratios.
b).
1.Operating profit margin = Operating profits / Sales
Pelican Paper = 6,750,000 / 27,000,000 = 0.25
Timberland Forest = 6,750,000 / 27,000,000 = 0.25
2.Net profit margin = earnings available for common stockholders / Sales
Pelican Paper = 3,985,200 / 27,000,000 = 0.1476
Timberland Forest = 3,726,000 / 27,000,000 = 0.138
3.Return on total assets = Earnings available for common stockholders / Total Assets
Pelican Paper = 3,985,200 / 10,300,000 = 0.3869
Timberland Forest = 3,726,000 / 10,300,000 = 0.3617
4.Return on common equity = Earnings available for common stockholders / Common stock equity
Pelican Paper = 3,985,200 / 9,100,000 = 0.4379
Timberland Forest = 3,726,000 / 4,800,000 = 0.7763
Pelican paper is not as profitable as Timberland Forest.
c).
i) By financing, Timberland Forest has gained access to resources that allow for operating maneuverability.
ii) Timberland has less resources free to work with so if something unforeseen happens then company may not be able to compensate and the financiers will suffer.