The Financial Statement Notes
Financial statements are accompanied by financial statement notes and supplementary information that help... Read More
Solvency describes a company’s ability to meet its long-term debt obligations.
Leverage ratios and coverage ratios are the two primary types of solvency ratios that are used in evaluating a company’s level of solvency. Leverage ratios focus on the balance sheet and measure the extent to which liabilities, instead of equity, are used to finance a company’s assets. Coverage ratios focus, instead, on the income statement and cash flows and measure a company’s ability to cover its debt-related payments.
The two primary types of solvency ratios are:
$$ \textbf{Leverage Ratios} $$
$$ \begin{array}{c|c} {\text{Debt-to-asset ratio}} & { \cfrac {\text{Total debt}^{\text A}} {\text{Total assets}} } \\ \hline {\text{Debt-to-capital ratio}} & { \cfrac {\text{Total debt}^{\text A}}{\text{Total debt}+\text{Total equity}} } \\ \hline {\text{Debt-to-equity ratio}} & { \cfrac {\text{Total debt}^{\text A}}{\text{Total equity}} } \\ \hline \text{Financial leverage ratio} & {\cfrac {\text{Average total assets}}{\text{Average equity}}} \\ \end{array} $$
A Debt is defined as the sum of interest-bearing short-term and long-term debt.
The first three leverage ratios use total debt in the numerator.
B EBIT is earnings before interest and taxes.
Question
Dandy Dosh Company has shareholders’ equity of $200,000, short-term liabilities amounting to $50,000, and long-term liabilities of $75,000. Dandy Dosh’s financial leverage ratio is closest to:
- 1.25.
- 1.375.
- 1.625.
Solution
The correct answer is C.
$$\text{Financial ratio} = \frac{\text{Average total assets}}{\text{Average shareholders’ equity}}$$
Where:
$$\text{Assets = Shareholders’ equity + Long-term liabilities + Short-term liabilities} = \$200,000 + \$75,000 + \$50,000 = \$325,000$$
Thus,
$$\text{Financial leverage ratio} = \frac{\$325,000}{\$200,000} = 1.625$$