Question

The relationship between financial leverage and profitability   Pelican​ Paper, Inc., and Timberland​ Forest, Inc., are rivals in the manufacture of craft papers. Some financial statement values for each company follow .

Item Pelican Paper, Inc. Timberland Forest, Inc.
Total assets $10,900,000 $10,900,000
Total equity (all common) 9900000 5400000
Total debt 1000000 5500000
Annual interest 100000 550000
Total sales 23000000 23000000
EBIT 5750000 5750000
Earnings available for
common stockholders 3394800 3174000
Use them in a ratio analysis that compares the​ firms' financial leverage and profitability.
The debt ratio for Pelican is ​%.
(Round to one decimal​ place.)
The debt ratio for Timberland is ​%.
(Round to one decimal​ place.)
The times interest earned ratio for Pelican is.​
(Round to one decimal​ place.)
The times interest earned ratio for Timberland is.
​ (Round to one decimal​ place.)
Discuss their financial risk and ability to cover the costs in relation to each other. ​ (Select all the answers that​ apply.)
A. Pelican has a much higher degree of financial leverage than does Timberland. As a​ result, Pelican's earnings will be more​volatile, causing the common stock owners to face greater risk.
B. ​Pelican's earnings will be more volatile. This additional risk is supported by the significantly lower times interest earned ratio of Pelican. Timberland can face a very large reduction in net income and still be able to cover its interest expense.
C. ​Timberland's earnings will be more volatile. This additional risk is supported by the significantly lower times interest earned ratio of Timberland. Pelican can face a very large reduction in net income and still be able to cover its interest expense.
D. Timberland has a much higher degree of financial leverage than does Pelican. As a​ result, Timberland's earnings will be more​volatile, causing the common stock owners to face greater risk.

Answer 1

Pelican​ Paper, Inc., and Timberland​ Forest, Inc.

Financial leverage and profitability ratios:

a) Debt Ratio = Total liabilities divided by Total assets x 100

Pelican = $1,000,000/$10,900,000 x 100

= 9.2%

Timberland = $5,500,000/$10,900,000 x 100

= 50%

Times Interest Earned Ratio = EBIT/Interest Expense

Pelican = $5,750,000/$100,000

= 57.5 times

Timberland = $5,750,000/$550,000

= 10.4 times

A discussion of their financial risk and ability to cover the costs in relation to each other:

C. ​Timberland's earnings will be more volatile. This additional risk is supported by the significantly lower times interest earned ratio of Timberland. Pelican can face a very large reduction in net income and still be able to cover its interest expense.

D. Timberland has a much higher degree of financial leverage than does Pelican. As a​ result, Timberland's earnings will be more​volatile, causing the common stock owners to face greater risk.

Step-by-step explanation:

a) Data

Financial Statement Values:

Item Pelican Paper, Inc. Timberland Forest, Inc.

Total assets $10,900,000 $10,900,000

Total equity (all common) 9,900.000 5,400,000

Total debt 1,000,000 5,500,000

Annual interest 100,000 550,000

Total sales 23,000,000 23,000,000

EBIT 5,750,000 5,750,000

Earnings available for

common stockholders 3,394,800 3,174,000

b) Creditors provide half of the finances and effectively own 50% of Timberland. This contrasts with the debt ratio of Pelican, where creditors can lay claim to only 9.2% of the assets of the firm. Furthermore, Pelican can settle its debts with current earnings 57.5 times, compared to Timberland's interest coverage of 10.4 times.