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The relationship between financial leverage and profitability Pelican? Paper, Inc
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 $10,800,000 $10,800,000
Total equity (all common) 9,400,000 6,200,000
Total debt 1,400,000 4,600,000
Annual interest 140,000 460,000
Total sales 23,000,000 23,000,000
EBIT 5,750,000 5,750,000
Earnings available for
common stockholders 3,394,800 3,174,000
. 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?
Please work out the solution and add how you got that solution. I have needed help on this for awhile and the last time I posted this question, the answers were wrong. Please help me, I appreciate it. Thanks!
Expert Solution
1) Computation of Debt Ratio and Times Interest Earned Ratio:
Debt Ratio = Total Debt /Total Asset
Debt Ratio of Pelican Paper Inc. = 1400000/10800000 = 0.13
Debt Ratio of Timberland Forest Inc. = 4600000/10800000 = 0.43
Times Interest Earned Ratio = EBIT/Interest Expense
For Pelican Paper Inc. = 5750000/140000 = 41.07
For Timberland Forest Inc. = 5750000/460000 = 12.50
The Time interest earned ratio of Pelican Paper inc is much higher than timberland forest which shows that pelican inc is more sound and has a greater ability to pay off its liabiliies and debt as compared to tiberland forest.
2) Computation of Operating profit margin, Net profit margin, Return on total assets and Return on common equity:
Operating Profit Margin = EBIT/ Sales Revenue
For Pelican Paper Inc. =5750000/23000000 = 0.25
For Timberland Forest Inc. = 5750000/23000000 = 0.25
Net Profit Margin = Net Income/Net Sales
For Pelican Paper Inc. = 3394800/23000000 = 0.148
For Timberland Forest Inc. = 3174000/23000000 = 0.138
Return on Total Assets = Average Net Income/ Total Assets
For Pelican Paper Inc. = 3394800/10800000
= 0.314 or 0.31
For Timberland Forest Inc. = 3174000/10800000
=0.294 or 0.29
Return on Common equity = Net income /Average common Shareholders equity
For Pelican Paper Inc. = 3394800/9400000= 0.36
For Timberland Forest Inc. = 3174000/6200000 = 0.51
c) By financing Timberland Forest has agined access to resources that allow for operating maneuverability. Timberland has less resources free to work with so if something unforseen happens then company may not be able to compensate and the financiers will suffer.
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