Leverage Ratios - Financial Accounting

1. A company reports net income of $240,000, income tax expense of $80,000, and interest expense of $100,000 for the year. What is the company's times interest earned (TIE) ratio?
   Answer: 4.20 The times interest earned (TIE) ratio is calculated as Earnings Before Interest and Taxes (EBIT) divided by Interest Expense. To find EBIT, one must add back interest and taxes to net income. EBIT = Net Income + Interest Expense + Tax Expense = $240,000 + $100,000 + $80,000 = $420,000. TIE = EBIT / Interest Expense = $420,000 / $100,000 = 4.20.
2. Coronado Corp. has a times interest earned ratio of 6.0, net income of $750,000, and a tax rate of 25%. What is Coronado's annual interest expense?
   Answer: $200,000 This is a multi-step problem that requires working backward from net income. First, calculate Earnings Before Tax (EBT): EBT = Net Income / (1 - Tax Rate) = $750,000 / (1 - 0.25) = $1,000,000. Second, use the relationship EBIT = EBT + Interest Expense (I). We also know TIE = EBIT / I. Substituting the first equation into the second gives: TIE = (EBT + I) / I. We are given TIE = 6.0 and we calculated EBT = $1,000,000. So, 6.0 = ($1,000,000 + I) / I. Solving for I: 6.0 I = $1,000,000 + I => 5.0 I = $1,000,000 => I = $200,000.
3. Apex Corporation reported the following for the current year: EBIT $450,000, Interest Expense $75,000, Income Tax Expense $93,750, and Preferred Dividends $30,000. If the company's times interest earned ratio needs to be at least 4.0 to maintain its current credit rating, what is the maximum additional annual interest expense the company can incur while maintaining this minimum ratio?
   Answer: $37,500, representing the difference between current coverage capacity and the minimum requirement Current TIE = $450,000 ÷ $75,000 = 6.0. For minimum TIE of 4.0: $450,000 ÷ (Total Interest) = 4.0, so Total Interest = $112,500. Additional interest = $112,500 - $75,000 = $37,500. Choice B gives total allowable interest, not additional. Choice C would result in TIE of 3.0. Choice D is arbitrary and doesn't relate to the calculation.
4. Over the past fiscal year, a company's debt-to-equity ratio increased from 0.8 to 1.5, while its times interest earned ratio decreased from 7.0 to 3.0. Which of the following events is the most likely single cause of these changes?
   Answer: The company acquired a major competitor by issuing a large amount of long-term debt. An increase in the debt-to-equity ratio means debt increased relative to equity. A decrease in the times interest earned ratio means EBIT decreased relative to interest expense. Acquiring a competitor by issuing debt would directly increase total debt, which increases the D/E ratio. It would also increase interest expense. Unless the acquired company immediately generated enough EBIT to offset the new interest expense, the TIE ratio would decrease. The other options are inconsistent with the observed changes.
5. A company with positive retained earnings uses cash on hand to repurchase a significant number of its own shares, which it holds as treasury stock. What is the immediate effect of this transaction on the company's debt-to-equity ratio?
   Answer: It increases, because cash and stockholders' equity both decrease. The debt-to-equity ratio is Total Liabilities / Total Equity. When a company buys back its own stock, it reduces cash (assets) and increases treasury stock (a contra-equity account). The increase in treasury stock reduces total stockholders' equity. The numerator, Total Liabilities, is unchanged. The denominator, Total Equity, decreases. A decrease in the denominator results in an increase in the ratio. Therefore, the debt-to-equity ratio increases.
6. A company has total liabilities of $3,000,000. Its equity consists of $1,000,000 in common stock and a retained deficit of $1,500,000. Which statement best describes the company's debt-to-equity ratio?
   Answer: The ratio is not a meaningful measure because stockholders' equity is negative. First, calculate total equity: Total Equity = Common Stock + Retained Earnings (Deficit) = $1,000,000 - $1,500,000 = -$500,000. A negative total equity indicates that liabilities exceed assets, meaning the company is insolvent. While the debt-to-equity ratio can be mathematically calculated as $3,000,000 / -$500,000 = -6.0, the result is not meaningful for typical financial analysis. A negative ratio does not provide a useful measure of leverage in the same way a positive ratio does. The key takeaway is the company's insolvency.
7. A company arranges with its bank to reclassify $10 million of debt due in six months to a new loan due in five years. The total principal amount of debt and the effective interest rate remain the same. What is the effect of this refinancing on the company's debt-to-equity and times interest earned ratios?
   Answer: Debt-to-equity is unchanged; times interest earned is unchanged. The debt-to-equity ratio is calculated using total liabilities. Reclassifying debt from short-term to long-term changes the composition of liabilities but not the total amount. Therefore, the debt-to-equity ratio is unchanged. The times interest earned ratio is EBIT / Interest Expense. The problem states that the interest rate remains the same, so interest expense is unchanged. As a result, the times interest earned ratio is also unchanged. While this transaction improves liquidity ratios (like the current ratio), it does not affect these specific leverage ratios.
8. Based on the provided data, what is Bramble Corp.'s debt-to-equity ratio?
   Answer: 1.00 First, calculate total liabilities (debt). This includes all forms of debt, both current and long-term. Total Liabilities = Accounts Payable + Bonds Payable = $150,000 + $500,000 = $650,000. Second, calculate total equity. Total Equity = Common Stock + Retained Earnings = $200,000 + $450,000 = $650,000. The Total Assets figure confirms the balance sheet equation ($650,000 Liabilities + $650,000 Equity = $1,300,000 Assets). Finally, calculate the ratio: Debt-to-Equity = Total Liabilities / Total Equity = $650,000 / $650,000 = 1.00.
9. In calculating the times interest earned ratio to assess a company's ability to meet its debt obligations from its normal, recurring business activities, how should a large, one-time gain from the sale of a factory be treated?
   Answer: It should be excluded from the numerator because it is a non-operating and non-recurring item. The purpose of the times interest earned ratio is to measure a company's ability to make interest payments using earnings from its ongoing operations. Therefore, the numerator should be a measure of recurring operating income (EBIT). A large, one-time gain from selling a factory is not part of normal operations and is unlikely to recur. Including it would distort the ratio and overstate the company's sustainable ability to cover interest payments. For analytical purposes, it should be excluded from EBIT.
10. A company has total assets of $2,500,000 and total liabilities of $1,500,000. The company then recognizes a $200,000 impairment loss on its goodwill. What is the company's debt-to-equity ratio after the impairment loss is recorded?
    Answer: 1.88 First, determine the initial stockholders' equity: Equity = Assets - Liabilities = $2,500,000 - $1,500,000 = $1,000,000. An impairment loss on goodwill is an expense that reduces net income, which in turn reduces retained earnings and total equity. The new equity is $1,000,000 - $200,000 = $800,000. The impairment does not affect total liabilities. The new debt-to-equity ratio is Total Liabilities / New Equity = $1,500,000 / $800,000 = 1.875, or 1.88.
11. Based on the financial data provided, what conclusions can be drawn about Phoenix Manufacturing's leverage position and interest coverage capability?
    Answer: Debt-to-equity ratio of 1.0 with times interest earned of 4.0, indicating balanced leverage and adequate coverage This question tests your ability to calculate and interpret two critical leverage ratios: debt-to-equity ratio and times interest earned. When analyzing a company's capital structure, these ratios reveal both the extent of financial leverage and the company's ability to service its debt obligations. To find the debt-to-equity ratio, you need total debt divided by total equity. Total debt includes both long-term debt ($1,800,000) and short-term debt ($450,000), giving you $2,250,000. Total equity consists of common stock ($600,000), retained earnings ($1,350,000), and additional paid-in capital ($300,000), totaling $2,250,000. Therefore: $\frac{2,250,000}{2,250,000} = 1.0$ For times interest earned, divide EBIT by interest expense: $\frac{540,000}{135,000} = 4.0$ Answer A incorrectly calculates a 1.5 debt-to-equity ratio, likely by excluding short-term debt or miscalculating equity components. The 5.0 times interest earned also suggests computational errors in the EBIT or interest figures. Answer B shows a 1.2 ratio, possibly from incorrectly categorizing some equity as debt, while the 4.5 coverage ratio indicates similar calculation mistakes. Answer C's 0.9 ratio might result from double-counting equity components or excluding legitimate debt, and the 3.5 coverage suggests errors in identifying the correct EBIT figure. Remember to always include all debt (short-term and long-term) when calculating leverage ratios, and ensure you're capturing all equity components from the balance sheet. These ratios are fundamental tools for assessing financial risk.
12. A company has a debt-to-equity ratio of 1.2 and total liabilities of $600,000. What are the company's total assets?
    Answer: $1,100,000 First, use the debt-to-equity ratio to find total equity. Debt-to-Equity = Total Liabilities / Total Equity. So, 1.2 = $600,000 / Total Equity. Solving for Total Equity gives Total Equity = $600,000 / 1.2 = $500,000. Second, use the accounting equation (Assets = Liabilities + Equity) to find total assets. Total Assets = Total Liabilities + Total Equity = $600,000 + $500,000 = $1,100,000.
13. A company with a debt-to-equity ratio greater than zero issues new shares of common stock for cash. Assuming the transaction is executed at a price above book value, what is the immediate effect on the company's debt-to-equity ratio?
    Answer: It decreases, because total equity increases while debt remains unchanged. The debt-to-equity ratio is Total Liabilities / Total Equity. When a company issues new shares for cash, its cash (an asset) increases and its common stock/APIC (equity) increases by the same amount. The numerator (Total Liabilities) is unchanged, while the denominator (Total Equity) increases. An increase in the denominator of a fraction results in a decrease in the value of the fraction. Therefore, the debt-to-equity ratio decreases.
14. What is the direct impact of capitalizing this operating lease on the firm's debt-to-equity ratio?
    Answer: It increases, because total liabilities increase while total equity remains unchanged. The debt-to-equity ratio is calculated as Total Liabilities / Total Equity. Capitalizing the lease increases total liabilities by adding a lease liability. The corresponding entry is an increase in assets (the right-of-use asset). There is no direct impact on total equity from this initial recognition. Therefore, the numerator (Total Liabilities) increases while the denominator (Total Equity) remains unchanged, causing the ratio to increase.
15. Based on the information from Paxton Industries' balance sheet, what is the company's debt-to-equity ratio?
    Answer: 0.92 First, calculate total liabilities (debt): Total Liabilities = Current Liabilities + Bonds Payable = $250,000 + $600,000 = $850,000. Second, calculate total stockholders' equity: Equity = Preferred Stock + Common Stock + APIC + Retained Earnings - Treasury Stock = $100,000 + $50,000 + $450,000 + $300,000 - $25,000 = $925,000. Finally, calculate the debt-to-equity ratio: D/E = Total Liabilities / Total Equity = $850,000 / $925,000 ≈ 0.92.
16. A company's balance sheet shows total assets of $1,200,000, common stock of $300,000, and retained earnings of $200,000. The company has no other equity accounts. What is the company's debt-to-equity ratio?
    Answer: 1.40 First, calculate total equity: Total Equity = Common Stock + Retained Earnings = $300,000 + $200,000 = $500,000. Second, calculate total liabilities using the accounting equation (Assets = Liabilities + Equity): Total Liabilities = Total Assets - Total Equity = $1,200,000 - $500,000 = $700,000. Finally, calculate the debt-to-equity ratio: Debt-to-Equity = Total Liabilities / Total Equity = $700,000 / $500,000 = 1.40.
17. If Meridian Industries proceeds with the additional debt issuance, what will be the company's new debt-to-equity ratio, and how will this compare to the industry benchmark of 1.2?
    Answer: 1.81, which is significantly above the industry benchmark and may indicate excessive leverage risk Current equity = $2,400,000 - $1,440,000 = $960,000. New total debt = $1,440,000 + $300,000 = $1,740,000. New debt-to-equity ratio = $1,740,000 ÷ $960,000 = 1.81. This is significantly above the 1.2 benchmark. Choice B incorrectly calculates the ratio. Choice C uses wrong figures. Choice D incorrectly includes assets in the calculation.
18. Vista Enterprises reports the following year-end balances: Bonds Payable $2,800,000, Notes Payable $700,000, Accounts Payable $450,000, Accrued Liabilities $150,000, Common Stock $1,000,000, Additional Paid-in Capital $800,000, and Retained Earnings $1,400,000. If the company's policy is to exclude non-interest-bearing liabilities from leverage calculations, what is Vista's debt-to-equity ratio?
    Answer: 1.09, calculated using only interest-bearing debt in the numerator and total equity in the denominator When analyzing leverage ratios, you need to pay close attention to what types of liabilities the company includes in its calculations. Different companies may use different policies, and the question will specify these parameters. Vista's policy excludes non-interest-bearing liabilities from leverage calculations, so you only include debt that carries interest expense. From the given balances, the interest-bearing debt consists of Bonds Payable ($2,800,000) and Notes Payable ($700,000), totaling $3,500,000. The total equity includes Common Stock ($1,000,000), Additional Paid-in Capital ($800,000), and Retained Earnings ($1,400,000), totaling $3,200,000. The debt-to-equity ratio is: $\frac{\$3,500,000}{\$3,200,000} = 1.09$ Answer B correctly identifies this calculation using only interest-bearing debt in the numerator and total equity in the denominator. Answer A incorrectly includes all liabilities ($4,100,000 total), adding Accounts Payable and Accrued Liabilities, which are non-interest-bearing and should be excluded per company policy. Answer C uses only long-term debt ($2,800,000) in the numerator, ignoring the Notes Payable which also bears interest. Answer D makes two errors: using total liabilities instead of just interest-bearing debt, and using only contributed capital ($1,800,000) instead of total equity in the denominator. Always read the company's specific policy on leverage calculations carefully. Many firms exclude operating liabilities like accounts payable since these don't represent borrowed capital with interest costs.
19. A company refinances $10 million of its 8% bonds payable with new 5% bonds payable of the same principal amount. Assuming the company's operating income remains constant, what is the most likely effect of this transaction on its times interest earned (TIE) ratio?
    Answer: It will increase because interest expense decreases. The TIE ratio is calculated as EBIT / Interest Expense. By refinancing debt at a lower interest rate (from 8% to 5%), the company's annual interest expense decreases. Since the numerator (EBIT) is assumed to be constant and the denominator (Interest Expense) decreases, the TIE ratio will increase, indicating an improved ability to cover interest payments.
20. A company has a times interest earned ratio of 4.0 and interest expense of $150,000. During the year, the company incurred income tax expense of $180,000. What was the company's net income for the period?
    Answer: $270,000 This requires working backward through the income statement. First, calculate EBIT using the TIE ratio: TIE = EBIT / Interest Expense => 4.0 = EBIT / $150,000 => EBIT = $600,000. Second, calculate Earnings Before Tax (EBT): EBT = EBIT - Interest Expense = $600,000 - $150,000 = $450,000. Finally, calculate Net Income: Net Income = EBT - Taxes = $450,000 - $180,000 = $270,000.

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