Chapter 14 Financial Statement Analysis 649
Given DreamWorks’ profitability, this much long-term debt would not be considered
reckless, and is actually an advantage to stockholders, due to positive leverage.
Ratio of Liabilities to Stockholders’ Equity
Claims against the total assets of a business are divided into two groups: (1) claims of
creditors and (2) claims of owners. The relationship between the total claims of the
creditors and owners—the ratio of liabilities to stockholders’ equity—is a leverage
measure that indicates the margin of safety for creditors. This ratio is used widely to
summarize a business’s aggregate leverage. The ratio also indicates the ability of the
business to withstand adverse business conditions. When the claims of creditors are
large in relation to the equity of the stockholders, there are usually significant interest
payments. If earnings decline to the point where the company is unable to meet its in-
terest payments, the business may be taken over by the creditors. This is what hap-
pened at Kmart.
The relationship between creditor and stockholders’ equity is shown in the verti-
cal analysis of the balance sheet. For example, the balance sheet of Pixar in Exhibit 3
indicates that on January 1, 2005, total liabilities represented 4.3% and stockholders’
equity represented 95.7% of the total liabilities and stockholders’ equity (100.0%).
Instead of expressing each item as a percent of the total, this relationship may be
expressed as a ratio of one to the other, as follows, for both Pixar and DreamWorks:
Pixar DreamWorks
(in millions, (in millions,
except ratio) except ratio)Total liabilities $ 54.90 $373.10
Total stockholders’ equity ÷ $1,220.10 ÷ $826.90
Ratio of liabilities to stockholders’ equity 0.04 0.45
The liability to stockholders’ equity ratio of 1.0 occurs when half of the total assets are
funded by debt and half are funded by stockholders’ equity (that is, they are equal).
This is an average ratio. Thus, Pixar’s ratio would be interpreted as very conservative
because it uses no long-term debt as discussed above. DreamWorks’ ratio is also con-
servative and would not be cause for concern. Both Pixar and DreamWorks must be
conservative with the use of debt because a string of box office failures could place ei-
ther company in financial stress.
Number of Times Interest Charges Earned
Corporations in some industries, such as airlines, normally have high ratios of debt to
stockholders’ equity. For such corporations, the relative risk of the debtholders is
normally measured as the number of times interest charges are earnedduring the
year. The higher the ratio, the lower the risk that interest payments will not be made
if earnings decrease. In other words, the higher the ratio, the greater the assurance that
interest payments will be made on a continuing basis. This measure also indicates the
general financial strength of the business, which is of interest to stockholders and em-
ployees as well as creditors.
The amount available to meet interest charges is not affected by taxes on income.
This is because interest is deductible in determining taxable income. Thus, the number
of times interest charges are earned for Pixar and DreamWorks is computed as shown
on the following page.