Answer:
Pelican Paper, Inc., and Timberland Forest, Inc.
Financial leverage and profitability Ratio Analysis
A. Computation of debt and coverage ratios:
1. debt ratio = Total debt to Total assets x 100
Pelican = $1,000,000/$10,000,000 x 100
= 10%
Timberland =v$5,000,000/$10,000,000 x 100
= 50%
2. times interest earned ratio = EBIT/Interests
Pelican = $6,250,000/$100,000
= 62.5 times
Timberland = $6,250,000/$500,000
= 12.5 times
A discussion of their financial risk and ability to cover the costs:
Pelican Paper's financial leverage is 10% compared to Timberland's 50%, showing that debt creditors finance and lay claim to half of the company's assets. This is very high and not attractive to potential investors and creditors. Timberland has already hampered its ability to borrow more as it is highly leveraged. Whereas Pelican Paper can meet its debt obligations and pay its interest expenses 62.5 times from current earnings, these pale in comparison with Timberland's 12.5 times, further jeopardizing its opportunities for more debt financing.
B. Calculation of the profitability ratios:
1. Operating profit margin = EBIT/Sales x 100
Pelican Paper = $6,250,000/$25,000,000 x 100 = 25%
Timberland = $6,250,000/$25,000,000 x 100 = 25%
2. Net profit margin = (EBIT less Interest)/Sales x 100
Pelican Paper = ($6,250,000 - $100,000)/$25,000,000 x 100
= $6,150,000/$25,000,000 x 100 = 24.6%
Timberland = ($6,250,000 - $500,000)/$25,000,000 x 100
= $5,750,000/$25,000,000 x 100 = 23%
3. Return on total assets = EBIT/Total Assets x 100
Pelican Paper = $6,250,000/$10,000,000 x 100
= 62.5%
Timberland = $6,250,000/$10,000,000 x 100
= 62.5%
4. Return on common equity = Earnings available to Common Stockholders/Equity x 100
Pelican = $3,690,000/$9,000,000 x 100
= 41%
Timberland = $3,450,000/$5,000,000 x 100
= 69%
A discussion of their profitability relative to one another:
The two companies make the same level of operating profit margin at 25%, but Pelican's net profit margin of 24.6% is better than Timberland's 23%. They show that Pelican's management has better ability to control expenses than Timberland's.
The returns on assets are similar for both companies, but Timberland performed better than Pelican Paper in terms of the return on equity. This shows that Timberland with ROE of 69% is making larger returns for its common stockholders than Pelican because it is leveraging debts, whose interests are tax-deductible, and also using less equity in generating the returns.
C. The larger debt of Timberland has made it more profitable than Pelican Paper because the debt interests are deductible from EBIT before tax expense is computed and it reduces the tax burden for the company, thus making it to pay less tax and saving more profits for distribution to its stockholders.
However, this higher return to the investors in Timberland also comes with higher risks, as the investors are exposed to debt risks, higher pressure to satisfy debt creditors, heightened interference and oversight from creditors since they own half of the assets of the company, and an increased threat of business takeover in case of debt default.
Explanation:
a) Data:
Items Pelican Paper, INC Timberland Forest, INC
Total assets $10,000,000 $10,000,000
Total equity 9,000,000 5,000,000
Total Debt 1,000,000 5,000,000
Annual Interest 100,000 500,000
Total Sales 25,000,000 25,000,000
EBIT 6,250,000 6,250,000
Earnings available for common
stockholders 3,690,000 3,450,000
b) Ratio computation and analysis help companies to compare their performances and positions with competitors. They can spot risks facing a company and even point out ways to address such business risks.