Question

Chapter 3 – Question 3

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.

Item                                          Pelican Paper, Inc.        Timberland Forest, Inc.

Total assets                              $10,600,000                  $10,600,000     

Total equity (all common)           9,900,000                      5,100,000         

Total debt                                 700,000                         5,500,000         

Annual interest                         70,000                         550,000            

Total sales                                24,000,000                    24,000,000       

EBIT                                         6,000,000                      6,000,000         

Earnings available for                           

common stockholders               3,542,400                      3,312,000         

Use them in a ratio analysis that compares the​ firms' financial leverage and profitability.

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?

Answer 1

Solution :-

(a) (1) Debt Ratio - Total liabilities (debt) Total Assets Now) Debt ratio Pelican Paper) - 700000 10600000 – 0.0660 or 6.60%. Debt gectio (Timberland Forest) - 5500000 – 0.5189 or 51.89%. - 10600000 Time Interest earned ratio EBIT Interest - مراحم Time Interest earned ratio Pelican Paper) booooo 6000000 - 85.7) 7oooo

Forest) Time Interest = 6000000 earned ratio Timberland - 10.91 550000 Timberland Forest is a much greater financial risk than Pelican paper as indicated by the higher debt ratio and lower Time interest earned&atio. (1) Operating profit margin. Operating profits sales Now, Operating pootit margin (Pelican Paper) - 6000000 – 0.25 - 24000000 Operating profit margin(Timberland Forest) 5 0.25 - 6000000 - 24000000

Net Profit margin - earnings available for Common Stock holders sales Now, Net profit margin(Pelican Paped) a 3542400 – O. 1476. 24000000 Forest) Net Profit margin Timberland 33120003 0.1380 24oooooo 13 Return on total assets Learnings available for Common Stock holders I Total assets رحال Return on Total assets (Pelican Paper) = 3542400 = 0.334. 10600000 e

Return on Total assets Timberland Forest) - 3312000 10600000 – 0.312 Return on common equity - Earnings available for Common Stockholders Common stock equity Now, Return on common equity (Pelican Paper) 3542400 – 0.358 - 9900000 Retuon on Common equity (Timberland Forest) - 3312000 = 0.649 510oooo Pelican Paper is not as profitable as Timberland Forest

ancing, Timberland Forest has gained access to resources that allow for operating maneuverability Timberland has less resources free to work with so if some- thing unforseen happens then company may not be able to compensate and the financiers will suffer.