302867 Leverage Ratios 1F

Question 1

Which one of the following statements about the interest coverage ratio is true?

It is a leverage ratio calculated with balance sheet information.

It is a liquidity ratio calculated with income statement information.

It is a liquidity ratio calculated with balance sheet information.

It is a leverage ratio calculated with income statement information.

Answer 1

It is a leverage ratio calculated with income statement information.

The interest coverage ratio is a leverage ratio calculated with income statement information. The interest coverage ratio, also known as times interest earned, is calculated by dividing the operating income by interest expense. Times interest earned is a leverage ratio that relies on activity accounts presented on the income statement. The ratio measures the firm’s ability to meet interest charges from net operating earnings.

The other answer choices are incorrect:

• A liquidity ratio calculated with income statement information: Liquidity ratios provide information about how well a firm is able to meet its current obligations. While the interest coverage ratio is calculated with income statement information, it is a leverage ratio, not a liquidity ratio.
• A liquidity ratio calculated with balance sheet information: Liquidity ratios provide information about how well a firm can meet its current obligations. The interest coverage ratio is not a liquidity ratio, and it is not calculated with balance sheet information. This ratio is a leverage ratio calculated with income statement information.
• A leverage ratio calculated with balance sheet information: Times interest earned is a leverage ratio and an income statement ratio that measures the firm’s ability to meet interest charges from net operating earnings. This ratio is calculated with income statement information, not balance sheet information.

Question 2

Leverage Ratios

Answer 2

Leverage ratios measure the degree of protection provided to long-term creditors and investors. They are also known as solvency ratios.

Leverage ratios measure funds supplied by creditors as compared with financing provided by owners and the degree to which the firm can afford the fixed charges (interest, lease expense, principle repayment, and preferred dividends) associated with debt (coverage). They reflect both risk and the solvency of the firm, i.e., the firm’s long-term financing and debt-paying ability.

Financial leverage reflects the extent to which the firm’s assets are financed by debt (compared to equity). It adds financial risk—additional variability to profitability. It is a measure of the advantage gained by the use of financing borrowed at a rate lower than the rate of return earned on total assets, and is computed as return on net worth minus ROI.

Leverage ratios are important because:

• creditors look for a margin of safety,
• owners desire to maximize allowable debt, and
• both owners and creditors want to balance increased return against increased risk.

Leverage ratios include the following:

• Balance sheet ratios:
  
  • Debt-to-equity ratio
  • Debt ratio
  • Equity ratio
• Income statement ratios:
  
  • Times interest earned
  • Fixed charge coverage
• Mixed ratio:
  
  • Cash flow coverage

Question 3

Times Interest Earned

Answer 3

Times interest earned is a leverage coverage ratio that measures the firm’s ability to meet interest charges from net operating earnings. It is a measure of solvency.

The computation is EBIT ÷ Interest expense, where EBIT = Earnings before interest and taxes, or Net operating income ÷ Interest expense.

There are limitations on the use of this ratio.

Example: Accrual income does not necessarily indicate the availability of cash to meet fixed charges associated with debt. Lease charges should be included, along with interest, in the denominator and deducted in the numerator. It can be argued that dividends paid on preferred stock should also be included in the denominator.

Question 4

2161.01

Answer 4

Objectives: Short-term liquidity ratios and other measures provide information about how well a firm is able to meet its currently maturing obligations.

1. Creditor and management: This is of special interest to creditors, but also important for management to know in order for them to be able to avoid embarrassing last-minute scrambles. Liquidity refers to the composition of current assets and liabilities, primarily assets. A higher proportion of cash or marketable securities is more liquid than a low proportion.
2. Short-term liquidity: Operating activity and cash flow ratios are analyzed as part of short-term liquidity. Operating activity ratios measure how effectively and efficiently the firm is carrying out its business—making sales, collecting on sales, and managing inventory. Companies with slow turning inventory and slow paying customers are less liquid. Cash flow gives an indication of the liquidity of a company as does the speed with which noncash current assets convert to cash.