Principles of Managerial Finance

CHAPTER 2 Financial Statements and Analysis 59

debt ratio
Measures the proportion of total
assets financed by the firm’s
creditors.

TABLE 2.6 Financial Statements Associated with

Patty’s Alternatives

No-debt plan Debt plan

Balance Sheets

Current assets $20,000 $20,000

Fixed assets  (^3)  (^0) , (^0)  (^0)  (^0)   (^3)  (^0) , (^0)  (^0)  (^0) 
Total assets $

5

0

,

0

0

0

$

5

0

,

0

0

0

Debt (12% interest) $ 0 $25,000
(1) Equity  (^5)  (^0) , (^0)  (^0)  (^0)   (^2)  (^5) , (^0)  (^0)  (^0) 
Total liabilities and equity $

5

0

,

0

0

0

$

5

0

,

0

0

0

Income Statements
Sales $30,000 $30,000
Less: Costs and operating
expenses  (^1)  (^8) , (^0)  (^0)  (^0)   (^1)  (^8) , (^0)  (^0)  (^0) 
Operating profits $12,000 $12,000
Less: Interest expense  (^0)  0.12$25,000 =  (^3) , (^0)  (^0)  (^0) 
Net profit before taxes $12,000 $ 9,000
Less: Taxes (rate = 40%)  (^4) , (^8)  (^0)  (^0)   (^3) , (^6)  (^0)  (^0) 
(2) Net profit after taxes $

7

,

2

0

0

$

5

,

4

0

0

Return on equity [(2)(1)]  1

4

.

4

%  2

1

.

6

$5,400 %
$25,000
$7,200
$50,000

13. Coverage ratios use data that are derived on an accrual basis(discussed in Chapter 1) to measure what in a strict
    sense should be measured on a cash basis.This occurs because debts are serviced by using cash flows, not the
    accounting values shown on the firm’s financial statements. But because it is difficult to determine cash flows avail-
    able for debt service from the firm’s financial statements, the calculation of coverage ratios as presented here is quite
    common thanks to the ready availability of financial statement data.

industry norms) may result in unnecessarily low risk and return. In general, the

lower the firm’s coverage ratios, the less certain it is to be able to pay fixed obli-

gations. If a firm is unable to pay these obligations, its creditors may seek imme-

diate repayment, which in most instances would force a firm into bankruptcy.

Two popular coverage ratios are the times interest earned ratio and the fixed-

payment coverage ratio.^13

Debt Ratio

The debt ratiomeasures the proportion of total assets financed by the firm’s cred-

itors. The higher this ratio, the greater the amount of other people’s money being

used to generate profits. The ratio is calculated as follows:

Debt ratio

Total liabilities



Total assets