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 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

Answer 1

		Pelican Paper	Timberland Forest
a]
i]	Debt ratio [Total debt/Total assets]	13.3%	50.0%
		[1300000/9800000]	[4900000/9800000]
ii]	Times interest earned ratio [EBIT/Annual interest]	42.31	11.22
		[5500000/130000]	[5500000/490000]
	Timberland has a very high debt ratio when compared with that of Pelican due to which its TIE
	is lower. It indicates that Timberland has higher risk and that its ability to cover interest expense
	is lower.
b]
i]	Operating profit margin [EBIT/Total sales]	25.0%	25.0%
		[5500000/22000000]	]5500000/22000000
ii]	Net profit margin [Earninga available for common stockholders/Total sales]	14.8%	13.8%
		[3247200/22000000]	[3036000/22000000]
iii]	Return on total assets [EBIT/Total assets]	56.1%	56.1%
		[5500000/9800000]	[5500000/9800000]
iv]	Return on common equity [Earnings available for common stockholders/Common equity]	38.2%	62.0%
		[3247200/8500000]	[3036000/4900000]
c]	The larger debt of Timberland has enabled it to magnify the ROTA of 56.1% into a higher ROE of 62.0%.
	In the case of Pelican, the ROE is, much lower at 38.2% for the same ROTA, the reason being its lower
	debt ratio.
	The risk that the investors in Timberland undertake [in comparison with investors of Pelican] is that
	they are burdened with a higher fixed cost of financing, that is interest on debt, which has to be paid
	irrespective of availability of profits. This can push the firm into serious liquidity and solvency crisis if,
	the EBIT turns out to be lower. Lower profits will also affect the possibility of repayment of the
	principal. Thus, higher debt increases the probability of bankruptcy, when the prospects are poor.