An important test of management’s ability to earn a return on funds
supplied from all sources is the rate of return on total assets. Tbc ‘income figure used in computing this ratio should’ be operating income, since in test expense and income taxes are determined by factors other than the efficient use of resources. Operating Income is earned throughout the year and therefore should he related to the average investment in assets during the ‘year.
The computation or this ratio of Sea-cliff Company is shown as follows, assuming total assets at the beginning of 2000 were $820,000 This ratio shows that the rate of return earned on the company’s assets has fallen in 200 I. Before drawing conclusions us to the effectiveness -of Scucli ff’s munificent, however. we should consider the trend in the return on assets earned by other companies of similar kind and size.leverage We introduced the concept-of leverage in Chapter 10. Basically, applying leverage mean
• using borrowed to earn a return than the covt of increasing net income and the return-on common stockholders’ equity. In other words, if you l’,111 borrow money at 12 and use II to earn 20 you will benefit by doing
However. s may he favorable or unfavorable to the holders of common If the rate of return on total assets should fall below the average rate of interest on borrowed capital. leverage will reduce net income and the return on common stud-holders’ equity. In this situation, paying off the loans that carry high interest rates would
appear to be a logical move. However, most companies do not have enough cash to Tire long-term debt on short notice. Therefore. the common stockholders may become locked in to the unfavorable effects of leverage.
In deciding how much leverage is appropriate. the common srockhoklcr should COIIsider the stability of the company’s return on as~cts as well a the relationship ‘or return 10 the average cost of borrowed capital.
If business incurs so much lkht that it becomes unable to meet the required interest and principal payments. the creditors may force liquidation or reorganization or the business. Debt Ratio ‘One indicator of the amount of leverage used a guileless it the ratio. This ratio mca-urcs the proportion of till’ total assets financed hy creditors. as distinguished from stockholders. It is computed hy dividing total
.A high debt ratio indicates an extensive use or leverage. that is. a liar proportion of Financing provided creditors. A low debt ratio, on the other hand. FindLaw that the bu-Lucius i-, making little use of leverage Sacrifice Company has a lower debt ratio in 2001 than in 2000. Is this favorable or unfavorable? From the viewpoint of the common stockholder, a high debt ratio will produce maximum benefits if management is able to earn a rate of return on assets greater than the rate of interest paid to creditors.
However. a high debt ratio can be very unfavorable if the return on assets falls below the rate of interest paid to creditors. Since the return on total assets earned by Radcliffe Company has declined from 19% in 2000 to <I relatively low 14% in 200 I. the common stockholders probably would not want to risk a high debt ratio. The action by management in 200i of retiring $50.000 in long-term liabilities will help to protect the common stockholders from the unfavorable effects of leverage if the rate of return on assets continues 10 decline.
Analysis by long-Term Creditors Bondholders and other long-term creditors are primarily interested in three factors: (I) the rate of return on their investment. (2) the firm’s ability to meet its interest requirements. and (3) the firm’s ability to repay the principal of the debt when it falls due.
Yield Rate on Bon.ds The yield rate on bonds or other long-term indebtedness cannot be computed in the same manner as the yield rate on shares of stock. because bonds. unlike stocks. have a definite maturity date and amount.
The ownership of a 12%. 10- year. $1,000 bond represents the right to receive $120 each year for 10 years plus the right to receive $1,000 at the end of 10 years.
If the market price of this bond is $950. the yield rate on an investment in the bond is the rate of interest that will make the present value of these two contractual rights equal to ‘the $950 market price. When bonds sell at maturity value. the yield rate is equal to the bond interest rate.
Tire yield rate varies inversely with changes ill the market price of the bond. If interest ratesrise, the market price of existing bonds will fall; if interest rates decline. the price, of bonds will rise. If the price of a bond is above maturity value. the yield rate is less than the bond interest rate; if the price of a bond is below maturity value, the yield rate is higher than the bond interest rate.
Interest Coverage Ratio Bondholders feel that their investments are relatively safe if . the issuing company earns enough income to cover its annual interest obligations by a wide margin. A common measure of creditors’ safety is the ratio of operating income available for the payment of interest to the annual interest ex-pense. called the interest coverage ratio. This computation for Seacliff Company would be as follows:The ratio remained unchanged at a satisfactory level during 2000.
A ratio of 5.3 times interest earned would be considered strong in many industries. In the electric utilities industry, for example, the interest coverage ratio for the leading companies presently averages about 3, with the ratios of individual companies varying from 2 10 6.