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Debt Coverage and Financial Risk

Chapter 2 - P20
The relationship between financial leverage and profitability: Pelican Paper, Inc., and Timberland Forest, Inc., is rivals in the manufacture of craft papers. Some financial statement values for each company follow: Use them in a ratio analysis that compares the firm's financial leverage and profitability.

Item 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, 00

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 profitability than Pelican Paper? What are the risks that Timberland's investors undertake when they choose to purchase its stock instead of PelicanĂ¢??s?


Solution Summary

A detailed discussion on the relationship between financial leverage and profitability, and a complete intergrative ratio analysis.