A company changed its strategic direction and undertook an aggressive growth strategy, acquiring a significant amount of new assets early in the current fiscal year. The purchase of these assets was financed by increased levels of debt, and that strategy proved to be very successful as net income increased at a significantly higher rate than the increase in interest expense.
(a) Because of this strategy, explain how the following ratios would most likely change during the year:
(1) Debt to total assets,
(2) Interest coverage, and
(3) Free cash flow (the company does not pay out dividends).
(b) When a company takes on new amounts of debt and profitability rises because of this, what happens to the relationship between the return on assets ratio and the return on common shareholders' equity ratio?