Question

3. 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.

Company A uses long-term debt to finance its assets, and company B uses capital generated from shareholders to finance its assets. Which company would be considered a financially leveraged firm?

Company A

Company B

Which of the following is true about the leveraging effect?

Under economic growth conditions, firms with relatively more leverage will have higher expected returns.

Under economic growth conditions, firms with relatively low leverage will have higher expected returns.

Blue Sky Drone Company has a total asset turnover ratio of 3.50x, 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 $1.75 million on which it pays a 11% interest rate.

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 Blue Sky Drone’s debt management ratios?

Ratio	Value
Debt ratio	24.51%, 56.37%, 31.86%, or 19.61%
Times-interest-earned ratio	130.91x, 54.55x, 36.37x, or 72.73x

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   high or low times-interest-earned ratios (TIE).