At the end of Year 1, the following information is available for ABC Company and XYZ Company:Statement DataABCXYZTotal Assets$2,000,000$1,600,000Total Liabilities1,200,0001,200,000Owners' Equity800,000400,000Net Income120,00080,000Required:a) For each company, calculate the debt-to-assets ratio. (Show your work.)b) For each company, calculate the return-on-equity ratio. (Show your work.)c) For each company, calculate the return-on-assets ratio.d) Identify which company has a greater level of debt risk. e) Explain the meaning of financial leverage.f) Identify which company is using financial leverage more successfully and explain why.
What will be an ideal response?
a)
Debt-to-assets ratio = Total debt ÷ Total assets:
ABC = $1,200,000 ÷ $2,000,000 = 0.60
XYZ = $1,200,000 ÷ $1,600,000 = 0.75
b)
Return-on-equity ratio = Net income ÷ Total stockholders' equity:
ABC = $120,000 ÷ $800,000 = 0.15
XYZ = $80,000 ÷ $400,000 = 0.20
c)
Return-on-assets ratio = Net income ÷ Total assets:
ABC = $120,000 ÷ $2,000,000 = 0.06
XYZ = $80,000 ÷ $1,600,000 = 0.05
d)
XYZ Company has the higher level of financial risk because 75% of its assets are financed by creditors. For ABC, 60% of the assets are financed by creditors.
e)
Financial leverage is the practice of using borrowed money to increase the return on stockholders' investment.
f)
XYZ Company is using financial leverage more favorably because it has a higher return-on-equity ratio. XYZ's return-on-equity is 20%, whereas ABC's return-on-equity ratio is 15%.
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What will be an ideal response?
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