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okmarks People Window Help xy Apia: Student Question /courses.aplia.com/af/servlet/quiz?quiz action takeQuiz&quizprobGuid; QNAPCOA8010100000041ca25b007000 Keep the Highest: /5 Attempts: Aa Aa E 4. Debt management ratios Companies have the opportunity to use varying amounts of different sources of financing to acquire their assets, including internal and external sources, and debt (borrowed) and equity funds. Which of the following is considered a financially leveraged firm? O A company that uses only equity to finance its assets O A company that uses debt to finance some of its assets Which of the following is true about the leveraging effect? O Interest on debt can be deducted from pre-tax income, resulting in a greater taxable income and a smaller available operating income. O Interest on debt is a tax deductible expense, which means that it can reduce a firm's taxable income and tax obligation Green Penguin Pencil Company has a total asset turnover ratio of 8.50x, net annual sales of $25 million, and operating expenses of $11 million (including depreciation and amortization). On its balance sheet and income statement, respectively, it reported total debt of $1.75 million on which it pays a 7% interest rate. To analyze a company's financial leverage situation, you need to measure the firm's debt management ratios. Based on the preceding nfarmation, what are the values for Green Penguin Pencil's debt management ratios? Ratio Value Debt ratico Times-interest-earned ratio Infuenced by a firm's ability to make interest payments and pay back its debt, if all else is equal, creditors would prefer to give loans to companies with debt ratios

Explanation / Answer

1) Financially leveraged firm - A company that uses debt to finance some of its assets

2) Leveraging effect - Interest on debt is a tax deductible expense, which means that it can reduce a firm's taxable income and tax obligation

3) i) Total asset turnover = Sales / Total assets

or, 8.50 = $25,000,000 / Total assets

or, Total assets = $2,941,176.47058

Debt ratio = Total debt / Total assets = $1,750,000 / $2,941,176.47058 = 0.595 or 0.60

ii) Times interest earned ratio = Income before interest and tax / Interest expense

Income before interest and tax = Sales - operating expenses = $25,000,000 - $11,000,000 = $14,000,000

Interest expense = $1,750,000 x 7% = $122,500

Times interest earned ratio = $14,000,000 / $122,500 = 114.2857 or 114.29

4) Creditors would prefer to give loans to companies with lower debt ratios.

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