Which one of the following is the best indicator of long-term debt paying ability?
Answer (D) is correct. The debt to total assets ratio is the best indicator of long-term debt paying ability. It measures the long-term debt burden carried by the company per dollar of assets.
The following information has been derived from the financial statements of Boutwell Company:
Current assets $640,000
Total assets 990,000
Long-term liabilities 130,000
Current ratio 3.2
The company’s debt to equity ratio is
Answer (A) is correct. Boutwell’s current liabilities are $200,000($640,000 ÷ 3.2) Thus its total debt load is $330,000 ($200,000 + $130,000) and its total equity is $660,000 ($990,000 – 330,000) Therefore Boutwell’s debt to equity ratio is 0.5 to 1 ($330,000 ÷ $660,000)
The interest expense for a company is equal to its earnings before interest and taxes (EBIT). The company’s tax rate is 40%. The company’s times interest earned ratio is equal to
Answer (B) is correct. The times interest earned ratio equals EBIT divided by interest expense. If numerator and denominator are equal, the ratio is 1.
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
Answer (C) is correct. Times 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).
The degree of operating leverage (DOL) is
Answer (B) is correct. The degree of operating leverage (DOL) is a measure of the change in operating income (or EBIT) associated with a given change in sales volume. Operating leverage arises from a high level of plant and machinery (i.e., fixed costs) in the production process.
For a firm with a degree of operating leverage of 3.5, an increase in sales of 6% will
Answer (C) is correct. A degree of operating leverage (DOL) of 3.5 means that operating income (EBIT) will increase 3.5 times greater than any sales increase. Multiplying 3.5 times the 6% sales increase results in a pre-tax profit increase of 21%.
This year, Nelson Industries increased earnings before interest and taxes (EBIT) by 17%. During the same period, net income after tax increased by 42%. The degree of financial leverage that existed during the year is
Answer (C) is correct. The percentage-change version of the degree of financial leverage equals the percentage change in net income over the percentage change in EBIT. Accordingly, Nelson’s degree of financial leverage is 2.47 (44% ÷ 17%)
A firm with a higher degree of operating leverage when compared to the industry average implies that the
Answer (B) is correct. Operating leverage is a measure of the degree to which fixed costs are used in the production process. A company with a higher percentage of fixed costs (higher operating leverage) has greater risk than one in the same industry that relies more heavily on variable costs. However, such a firm is also able to expand production rapidly in times of higher product demand. Thus, the more leveraged a firm is in its operations, the more sensitive operating income is to changes in sales volume.
A degree of operating leverage of 3 at 5,000 units means that a
Answer (C) is correct. The degree of operating leverage (DOL) is the multiple of contribution margin over operating income (also called earnings before interest and taxes, or EBIT). A high multiple indicates heavy use of fixed costs in the firm’s operations This firm’s contribution margin is 3 times EBIT. Thus, a given percentage change in sales will result in a change 3 times as great in EBIT.
Firms with high degrees of financial leverage would be best characterized as having
Answer (A) is correct. The degree of financial leverage (DFL) is the multiple of operating income (or earnings before interest and taxes, called EBIT) over earnings before taxes (EBT). A high multiple indicates heavy use of fixed costs in the firm’s capital structure revealed by high interest payments on debt.