Chapter 3, Problem 3.20P

The relationship between financial leverage and profitability Pelican Paper Inc. and Timberland Forest Inc. are rivals in the manufacture of craft papers. Some financial statement values for each company follow. Use them in a ratio analysis that compares the firms’ financial leverage and profitability.

Item	Pelican Paper	Timberland Forest
Total assets	$10,000,000	$10,000,000
Total equity (all common)	9,000,000	5,000,000
Total debt	1,000,000	5,000,000
Annual interest	100,000	500,000
Total sales	25,000,000	25,000,000
EBIT	6,250,000	6,250,000
Earnings available for common stockholders	3,690,000	3,450,000

1. a. Calculate the following debt and coverage ratios for the two companies. Discuss their financial risk and ability to cover the costs in relation to each other.
   1. 1. Debt ratio
   2. 2. Times interest earned ratio
2. b. Calculate the following profitability ratios for the two companies. Discuss their profitability relative to one another.
   1. 1. Operating profit margin
   2. 2. Net profit margin
   3. 3. Return on total assets
   4. 4. Return on common equity
3. c. In what way has the larger debt of Timberland Forest made it more profitable than Pelican Paper? What are the risks that Timberland’s investors undertake when they choose to purchase its stock instead of Pelican’s?