Introduction to Corporate Finance

2: Financial Statement and Cash Flow Analysis

The debt ratio measures the proportion of total assets financed by the company’s creditors. The higher

this ratio, the greater is the company’s reliance on borrowed money to finance its activities. The ratio

equals total liabilities divided by total assets. GPC’s debt ratio in 2016 was 0.551, or 55.1%:

Debtratio====

Totalliabilities

Totalassets

$5,281

$9,589

0.551 55.1%

This figure indicates that the company has financed more than half of its assets with debt.

A close cousin of the debt ratio is the assets-to-equity (A/E) ratio, sometimes called the equity multiplier:

Assets-to-equityratio===

Totalassets

Ordinary shares

$9,589

$4,278

2.24

Note that the denominator of this ratio uses only ordinary shares equity of $4,278 ($4,308 of total

equity – $30 of preferred equity). The resulting value indicates that GPC’s assets in 2016 were 2.24

times greater than its equity. This value seems reasonable given that the debt ratio indicates slightly more

than half (55.1%) of GPC’s assets in 2016 were financed with debt. The high equity multiplier indicates

high debt and low equity, whereas a low equity multiplier indicates low debt and high equity.

An alternative measure that focuses solely on the company’s long-term debt is the debt-to-equity ratio.

It is calculated as long-term debt divided by shareholders’ equity. The 2016 value of this ratio for GPC

is calculated as follows:

Debt-to-equityratio====

Long-termdebt

Shareholders’equity

$1,76 0

$4,30 8

0.40940.9%

GPC’s long-term debts were therefore only 40.9% as large as its shareholders’ equity. A word of

caution: Both the debt ratio and the debt-to-equity ratio use book values of debt, equity and assets.

Analysts should be aware that the market values of these variables may differ substantially from their

book values.

The times interest earned ratio measures the company’s ability to make contractual interest payments.

It equals earnings before interest and taxes divided by interest expense. A higher ratio indicates a greater

capacity to meet scheduled payments. The times interest earned ratio for GPC in 2016 was equal to

13.59, indicating that the company could experience a substantial decline in earnings and still meet its

interest obligations:

Timesinterest earned===

Earningsbefore interest andtaxes

Interest expense

$1,671

$123

13.59

2-3e PrOFITABILITY rATIOS

Several measures of profitability relate a company’s earnings to its sales, assets or equity. Profitability

ratios are among the most closely watched and widely quoted financial ratios. Many companies link

employee bonuses to profitability ratios, and share prices react sharply to unexpected changes in these

measures.

The gross profit margin measures the percentage of each sales dollar remaining after the company has

paid for its goods. The higher the gross profit margin, in general, the better. GPC’s gross profit margin in

2016 is 33.7%:

Grossprofitmargin====

Grossprofit

Sales

$4,324

$12,843

0.337 33.7%

debt ratio

A measure of the proportion

of total assets financed by a

company’s creditors

assets-to-equity (A/E)

ratio

A measure of the proportion

of total assets financed by a

company’s equity. Also called

the equity multiplier

equity multiplier

A measure of the proportion

of total assets financed by a

company’s equity. Also called

the assets-to-equity (A/E) ratio

debt-to-equity ratio

A measure of the company’s

financial leverage, calculated

by dividing long-term debt by

shareholders’ equity

times interest earned ratio

A measure of the company’s

ability to make contractual

interest payments, calculated

by dividing earnings before

interest and taxes by interest

expense

LO2.4

gross profit margin

A measure of profitability that

represents the percentage of

each sales dollar remaining

after a company has paid for

its goods