Chapter 3 Question 3

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 $10,600,000 $10,600,000

Total equity (all common) 9,900,000 5,100,000

Total debt 700,000 5,500,000

Annual interest 70,000 550,000

Total sales 24,000,000 24,000,000

EBIT 6,000,000 6,000,000

Earnings available for

common stockholders 3,542,400 3,312,000

Use them in a ratio analysis that compares the firms' financial leverage and profitability.

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