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# Comparative Analysis of Profitability and Financial Leverage

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The problem I am having trouble with is 11.11.

The numbers in the columns are kind of hard to see on the attached file, they are:

Coke Pepsi
Net Revenues \$31,994 \$43,251
Net Income 5,807 5,142
Total Assets, 01/01/08 43,269 34,628
Total Liabilities, 01/01/08 21,525 17,394
Total Liabilities, 12/31/08 20,047 23,888
Total Stockholders Equity,12/31/08 20,472 12,203.

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## SOLUTION This solution is FREE courtesy of BrainMass!

Part A

The first step in calculating these ratios is making sure that you know the formulas. A trick I use to remember these is that ratios that have the word 'return' in their name have net income in the numerator. This makes sense because net income is an indicator of the return on an investment, assets, equity, etc.

Return on equity (ROE) = Net income / Shareholders' equity

Coke ROE = 5,807 / 20,472 = 0.284 or 28.4%

Pepsi ROE = 5,142 / 12,203 = 0.421 or 42.1%

Return on investment (ROI) = Net income / Average total assets

Average total assets = (beginning of period total assets + end of period total assets) / 2

With the data given, we must calculate ending total assets before we can calculate average total assets. We know that the balance sheet equation (assets = liabilities + shareholders' equity) must hold true, therefore we can use the ending total liabilities and ending shareholders' equity to calculate the ending total assets.

Coke:
Assets = Liabilities + Shareholders' equity
Assets = 20,047 + 20,472 = 40,546
Average total assets = (43,269 + 40,546) / 2 = 41,907.50
ROI = 5,807 / 41,907.50 = 0.139 or 13.9%

Pepsi:
Assets = Liabilities + Shareholders' equity
Assets = 23,888 + 12,203 = 36,091
Average total assets = (34,628 + 36,091) / 2 = 35,359.50
ROI = 5,142 / 35,359.50 = 0.145 or 14.5%

Part B

Financial leverage refers to the volatility in operating income as a result of decisions to use different relative proportions of debt and equity as sources of financing. With debt, interest expense payments must be made therefore the company incurs this expense each period, which reduces income by this amount. With equity financing, payments such as dividends are made at the discretion of the board of directors and are therefore not required. As a result, expenses that must be paid each period are greater when more debt is used; therefore it takes a smaller decline in business volume to reduce income when more debt financing is used relative to equity. To put this into other words, income is more volatile when more debt is used - it will fluctuate more with changes in business or sales volume, therefore we say that the firm has more financial leverage.

When a firm uses only equity financing (100% equity and 0% debt), its ROI will be equal to ROE. ROE increases as the use of debt financing increases.

Pepsi has an ROE that exceeds its ROI by an amount far greater than Coke's ROE exceeds its ROI. This implies that Pepsi uses a greater proportion of debt financing and is therefore more financially leveraged.

Part C

The key to starting this question is knowing the formulas.

Debt ratio = Total Debt / Total Assets

Debt/Equity ratio = Total Debt / Total Equity

Coke:
Debt ratio = 20,047 / 43,269 = 0.463
Debt/Equity ratio = 20,047 / 20,472 = 0.979

Pepsi:
Debt ratio = 23,888 / 34,628 = 0.690
Debt/Equity ratio = 23,888 / 12,203 = 1.96

Part D

The debt ratio indicates the proportion of a company's assets that are financed with debt. A higher debt ratio means that more of the company's assets are financed with debt and the firm is said to be more highly leveraged. Pepsi has a higher debt ratio than Coke which suggests that Pepsi is more financially leveraged than Coke.

The debt/equity ratio indicates the relative amounts of debt versus equity financing used by the firm. A higher ratio indicates more debt financing relative to equity financing, and therefore more earnings volatility or more leverage due to the fixed nature of interest expenses associated with debt. The debt/equity ratio of Pepsi is greater than that of Coke, which is consistent with the conclusion drawn from the debt ratio that Pepsi is more highly leveraged than coke.

The results of the debt ratio and debt/equity ratio are also consistent with conclusions drawn in part b.

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