1.3 Solvency Flashcards
Formula for total debt-to-total-capital ratio
Total debt to capital ratio = Total debt / Total Capital
Formula for debt to equity ratio
Debt to equity ratio = Total debt / stockholder’s equity
It reflects long-term debt-payment ability. A low ratio means a lower relative debt burden and thus better chances of repayment of creditors.
Formula for times interest earned
Times interest earned ratio = EBIT / Interest Expense
an income statement approach to evaluating a firm’s ongoing ability to meet the interest payments on its debt obligations.
Selected data from Ostrander Corporation’s financial statements for the years indicated are presented in thousands.
Year 2 Operations
Net credit sales $4,175
Cost of goods sold 2,880
Interest expense 50
Income tax 120
Gain on disposal of a segment (net of tax) 210
Administrative expense 950
Net income 385
December 31
Year 2 & Year 1
Cash $32 & $28
Trading securities 169 & 172
Accounts receivable (net) 210 & 204
Merchandise inventory 440 & 420
Tangible fixed assets 480 & 440
Total assets 1,397 & 1,320
Current liabilities 370 & 368
Total liabilities 790 & 750
Common stock outstanding 226 & 210
Retained earnings 381 & 360
The times interest earned ratio for Ostrander Corporation for Year 2 is
A. .57 times.
B. 7.70 times.
C. 3.50 times.
D. 6.90 times.
D. 6.90 times.
The times interest earned ratio is computed by dividing earnings before interest and taxes by interest expense.
Net income of $385, minus the disposal gain of $210, is added to income taxes of $120 and interest expense of $50 to produce a ratio numerator of $345. Dividing $345 by $50 results in an interest coverage of 6.90 times.
Selected data from Ostrander Corporation’s financial statements for the years indicated are presented in thousands.
Year 2 Operations
Net credit sales $4,175
Cost of goods sold 2,880
Interest expense 50
Income tax 120
Gain on disposal of a segment (net of tax) 210
Administrative expense 950
Net income 385
December 31
Year 2 & Year 1
Cash $32 & $28
Trading securities 169 & 172
Accounts receivable (net) 210 & 204
Merchandise inventory 440 & 420
Tangible fixed assets 480 & 440
Total assets 1,397 & 1,320
Current liabilities 370 & 368
Total liabilities 790 & 750
Common stock outstanding 226 & 210
Retained earnings 381 & 360
The total debt to equity ratio for Ostrander Corporation in Year 2 is
A. 3.49
B. 0.77
C. 2.07
D. 1.30
D. 1.30
Total equity consists of the $226 of capital stock and $381 of retained earnings, or $607. Debt is given as the $790 of total liabilities. Thus, the ratio is 1.30 ($790 / $607)
A debt to equity ratio is
A. About the same as the debt to assets ratio.
B. Higher than or equal to the debt to assets ratio.
C. Lower than or equal to the debt to assets ratio.
D. Not correlated with the debt to assets ratio.
B. Higher than or equal to the debt to assets ratio.
Because debt plus equity equals assets, a debt to equity ratio would have a lower denominator than a debt to assets ratio. Thus, the debt to equity ratio would be higher than the debt to assets ratio.
Which one of the following factors would likely cause a firm to increase its use of debt financing as measured by the debt to total capital ratio?
A. Increased economic uncertainty.
B. An increase in the degree of operating leverage.
C. An increase in the price-earnings ratio.
D. An increase in the corporate income tax rate.
D. An increase in the corporate income tax rate.
Debt financing usually has a lower cost than equity financing because interest payments are tax deductible. If tax rates rise, debt becomes even more desirable because the tax shield becomes more valuable. The disadvantages of debt include the increase in fixed payments (interest). Thus, in an unstable economy, debt represents a greater risk to a firm than equity financing.
Assume the following information pertains to Ramer Company, Matson Company, and for their common industry for a recent year.
Current ratio
- Ramer: 3.50
- Matson: 2.80
- Industry Average:3.00
Accounts receivable turnover
- Ramer: 5.00
- Matson: 8.10
- Industry Average: 6.00
Inventory turnover
- Ramer: 6.20
- Matson: 8.00
- Industry Average: 6.10
Times interest earned
- Ramer: 9.00
- Matson: 12.30
- Industry Average:10.40
Debt to equity ratio
- Ramer: 0.70
- Matson: 0.40
- Industry Average: 0.55
Return on investment
- Ramer: 0.15
- Matson: 0.12
- Industry Average: 0.15
Dividend payout ratio
- Ramer: 0.80
- Matson: 0.60
- Industry Average: 0.55
Earnings per share
- Ramer: $3.00
- Matson: $2.00
- Industry Average: –
The attitudes of both Ramer and Matson concerning risk are best explained by the
A. Current ratio, accounts receivable turnover, and inventory turnover.
B. Dividend payout ratio and earnings per share.
C. Current ratio and earnings per share.
D. Debt to equity ratio and times interest earned.
D. Debt to equity ratio and times interest earned.
Matson is the more conservative company because it is less highly leveraged (lower debt to equity ratio and a higher interest coverage). Moreover, it also pays out a smaller portion of its earnings in the form of dividends (lower dividend payout ratio). These ratios reflect management intent.
Ability of a business to meet its long-term obligations. This ability is related to the extent to which the business uses debt versus equity financing
Solvency
What is capital structure?
A firm’s capital structure includes its sources of financing, both long- and short-term. The sources of financing may be either in the form of debt (external financing) or equity (internal financing).
Which of the following is the best indicator of long-term debt paying ability?
A. Working capital turnover
B. Asset turnover
C. Current ratio
D. Debt to total assets ratio
D. Debt to total assets ratio
A&C are short-term
Debt to total assets ratio (also called debt ratio) is numerically identical to..
Debt to total capital ratio
The following information pertains to Ali Corp. as of and for the year ended December 31:
Liabilities $60,000
Equity $500,000
Shares of common stock issued and outstanding 10,000
Net income $30,000
During the year, Ali’s officers exercised share options for 1,000 shares of stock at an option price of $8 per share. What was the effect of exercising the share options?
A. Debt-to-equity ratio decreased to 12%
B. Earnings per share increased by $0.33
C. Asset turnover increased to 5.4%
D. No ratios were affected
A. Debt-to-equity ratio decreased to 12%
Exercising share options improves (decreases) the debt to equity ratio because equity is increased with no effect on debt. When share options are exercised, common stock, additional paid-in-capital, and cash are increased.
- Earnings per share (EPS) decreases when the number of shares outstanding increases
- Asset turnover = net sales / average assets. The exercise share options increases assets and decreases the ratio.
A company has interest expense of $4 million, sales revenue of $50 million, earnings before interest and taxes of $20 million, and an income tax rate of 35%. This company has a times-interest-earned ratio of
A. 5.0
B. 12.5
C. 7.5
D. 0.2
A. 5.0
Time interest earned is found by dividing earnings before interest and taxes (EBIT) by interest expense. Therefore, the times-interest-earned ratio is 5.0 ($20 million / $4 million).
Selected financial data of Draco Corporation for the year ended December 31 are as follows. Common stock dividends were $120,000.
Operating income $900,000
Interest expense (100,000)
Income before income tax $800,000
Income tax expense (320,000)
Net income $480,000
Preferred stock dividends (200,000)
Net income available to common shareholders $280,000
The times-interest-earned ratio is
A. 2.8 to 1.
B. 9.0 to 1.
C. 8.0 to 1.
D. 4.8 to 1.
B. 9.0 to 1.
The times-interest earned ratio is measure of the firm’s ability to pay interest on debt. It equals earnings before interest and taxes divided by the amount of interest.
$900,000 / 100,000 = 9.0
