Financial Statements and External Decision Making
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MODULE A
Answers to End-of-Chapter Assignments Questions Q1. Focus of Creditors When Analyzing Financial Statements. When lenders or potential creditors review financial statements, what is the primary focus of creditors with a short-term focus? Those with a longterm focus? Answer. Short-term creditors mainly focus on liquidity (the ability of a firm to meet its short-term obligations); long-term creditors mainly focus on solvency (the firm’s long-term profitability and longterm asset position) Q2. Purpose of Ratios. Financial analysts use ratio analysis to help understand the firm. Module A introduced many common ratios. Why does a financial analyst construct a ratio (i.e., what is the purpose of constructing a ratio)? Answer. A ratio is a summary statistic that standardizes the way data are presented. Standardized statistics are easier to compare over time and across firms. For example, ROA summarizes the relationship between net income and assets. Analysts can easily track a firm’s performance relative to its asset base over time by comparing ROA over time. Also, analysts use ROA to compare performance across firms. To glean even more information about the relationship between net income and assets, ROA can be broken down into its components, net profit margin ratio and asset turnover ratio. Q3. Profitability Ratios. In the text, we discussed two overall profitability ratios, one from the “all capital providers point of view” and one from the “common equity holders’ point of view.” What are the two ratios? Which ratio relates to each of the different points of view? Answer. ROA is the summary ratio applicable to the “all capital providers point of view;” ROCE is the summary ratio applicable to the “common equity holders’ point of view.” Q4. ROA. Provide the ratio definition of ROA. Net profit margin ratio and asset turnover ratio are the two components of ROA. Provide these definitions. Briefly explain what information is conveyed by the ratios. Answer. ROA (return on assets) = (net income + interest expense, net of income taxes) average total assets, which also = net profit margin ratio x asset turnover ratio. ROA is an efficiency measure of how much profit the firm generated per dollar of assets. In general, firms that generate greater profit per dollar of assets are more efficient. Net profit margin ratio = [net income + (1 - t) interest expense] sales. This ratio is also an efficiency measure of a firm’s profit per dollar of sales. In general, firms that generate greater profit per dollar of sales are more efficient. The denominator is affected by firm actions to increase sales, while the numerator is affected by firm actions that affect expenses (i.e., all other things held constant, reducing
2 expenses increases the net profit ratio; increasing expenses decreases the ratio).
Module A
Asset turnover ratio = sales average total assets. This ratio is an efficiency measure of the firms sales per dollar of assets. In general, firms that generate greater sales per dollar of assets are more efficient. The ratio is affected by firm decisions about the level of assets maintained and decisions that affect sales. Q5. ROCE. Provide the ratio definition of ROCE. ROA, common earnings leverage ratio, and capital structure leverage ratio are the three components of ROCE. Provide these definitions. Briefly explain what information is conveyed by the ratios. Answer. ROCE (return on common equity) in reduced form = (net income - preferred stock dividends) / average common stockholders' equity. In expanded form, ROCE = ROA x common earnings leverage ratio x capital structure leverage ratio. ROCE is an efficiency ratio that expresses firm profitability (after meeting preferred dividend obligations) per dollar of common stockholders’ equity. In general, stockholders prefer firms that produce higher earnings per dollar of stockholders’ equity. ROCE is linked to the operating, investing, and financing activities of the firm. ROA = (net income + interest expense, net of income taxes) average total assets, which also = net profit margin ratio x asset turnover ratio. ROA is an efficiency measure of how much profit the firm generated per dollar of assets. In general, firms that generate greater profit per dollar of assets are more efficient. Common earnings leverage ratio = (net income - preferred stock dividends) [net income + (1 - t) interest expense]. This ratio expresses the negative effects of capital structure on ROCE. Financing the firm with preferred stock necessitates the payment of preferred dividends, which decreases the numerator and reduces the effect on ROA. Similarly, financing the firm with debt necessitates the payment of interest, which increases the denominator and reduces the effect on ROCE. Capital structure leverage ratio = average total assets average common stockholders' equity. This ratio expresses the positive effects of using debt to increase the returns to common stockholders . Using debt to finance assets increases the numerator but does not affect the denominator, which increases the ratio and ROCE. Q6. Ratios Related to Short-Term Liquidity Risk. List and define the ratios for the following items that are used to assess short-term liquidity risk: current ratio, quick ratio, accounts receivable turnover ratio (and the related number of days of receivables), accounts payable turnover ratio, inventory turnover ratio, and cash flow from operations to current liabilities ratio. Try to write the definitions from memory or guess at the definition before turning to the text to find the formula. Current ratio = current assets current liabilities Quick ratio = quick assets current liabilities = (cash and cash equivalents + marketable securities + receivables) current liabilities Accounts receivable turnover ratio = sales average accounts receivable. This ratio can be used to
Financial Statements and External Decision Making
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calculate the average number of days of receivables outstanding by dividing 365 by the accounts receivable turnover ratio Accounts payable turnover ratio = purchases average accounts payable Inventory turnover ratio = cost of goods sold average inventory Cash flow from operations to current liabilities ratio = cash flow from operations average current liabilities Q7. Ratios Related to Long-Term Solvency Risk. List and define the ratios for the following items that are used to assess long-term solvency risk: long-term debt to equity ratio, long-term debt to total assets ratio, interest coverage ratio, operating cash flow to total liabilities ratio, and operating cash flow to total capital expenditures ratio. Try to write the definitions from memory or guess at the definition before turning to the text to find the formula. Answer. Long-term debt to equity ratio = long-term debt shareholders' equity. Shareholders’ equity can be defined either as the book value of shareholders’ equity or the market value of shareholders’ equity. We use the balance sheet category long-term debt in computing this ratio. Long-term debt can also be defined as total noncurrent liabilities. Long-term debt to total assets ratio = long-term debt total assets. Interest coverage ratio = (Income before income taxes + Interest expense) Interest expense. Frequently, this ratio is labeled as times interest earned. Operating cash flow to total liabilities ratio = operating cash flow average total liabilities. Operating cash flow to capital expenditures ratio = operating cash flow capital expenditures. Q8. Ratios and the Firm’s Business Strategy. An analyst who uses ratios is attempting to understand the firm’s business strategy. The firm’s business strategy is affected by industry conditions and the firm’s approach to dealing with competition (competitive strategy). List some of the factors used to analyze conditions and the firm’s competitive strategy. Answer. Factors related to industry conditions include the industry growth rate, degree of firm concentration, degree of product differentiation, economies of scale, degree of industry cyclicality and exit barriers, legal barriers to entry, and the relative bargaining power of buyers and suppliers and access to distribution channels. The firm’s competitive strategy includes the firm’s approach to cost leadership and product differentiation, and the ability to acquire unique core competencies and to create a value change (unique sequence of events that creates value). Q9. Accounting Quality. Financial analysts are interested in the quality of the amounts presented in financial statements. What is accounting quality? Answer. We broadly define accounting quality as the ability of the amounts reflected in financial
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Module A
statements to enable financial analysts to assess and predict the sustainability of current financial characteristics. In general, accounting quality increases if management (1) has a reputation for prompt, truthful reporting (as opposed to a tendency to hold back important financial information and a tendency to manipulate earnings), (2) provides more (as opposed to less) disclosure, and (3) uses conservative (as opposed to aggressive) assumptions in applying GAAP. The ability of a firm’s earnings to persist also increases accounting quality. Problems 1. Compute Ratios for Southwest Airlines. The complete 1998 GAAP financial statements for Southwest Airlines Co. are presented in Appendix C. Use these statements to calculate the ratios introduced in this module as follows: a. Return on Assets (ROA) and Related Ratios. Compute Southwest Airlines’ 1998 ROA using the overall ratio definition introduced in the text. Next, compute ROA a second time using the net profit margin ratio and asset turnover ratio components. Finally, compute Southwest Airlines’ 1998 ratios for accounts receivable turnover, inventory turnover, fixed asset turnover, and gross margin. Southwest Airlines breaks down operating expenses into several categories on the income statement. Compute the total operating expense ratio (total operating expenses total operating revenue) and the salaries, wages, and benefits expense ratio (salaries, wages, and benefits expense total operating revenue). Use an effective tax rate of 40%. Note: because Southwest Airlines is
a service company, some of these ratios are inappropriate. Indicate which of the ratios generally would not be computed for service companies.
Answer ROA (overall ratio) = (Net income + Interest expense, net of income taxes) Average total assets = ($433,431,000 + $56,276,000 (1-0.4)) $4,481,078,000 = 10.43%, where average total assets = ($4,715,996,000 + $4,246,160,000) 2 = $4,481,078,000. ROA (using component parts) = Net profit margin ratio x Asset turnover ratio = [(Net income + (1 - t) Interest expense) Sales] x (Sales Average total assets) = [($433,431,000 + $56,276,000 (1-.04)) $4,163,980,000] x ($4,163,980,000 $4,481,078,000) = 11.22% x .9292 =10.43%, where we use total operating revenues instead of sales and average total assets = ($4,715,996,000 + $4,246,160,000) 2 = $4,481,078,000. Accounts receivable turnover ratio = Sales Average accounts receivable = $4,163,980,000 $82,664,500 = 50.37, where average accounts receivable = ($88,799,000 + $76,530,000) 2 = $82,664,500. Inventory turnover ratio = Cost of goods sold Average inventory. Note that as a service company, Southwest Airlines does not report cost of goods sold. Therefore, the inventory turnover ratio is not computed. Fixed asset turnover ratio = Sales Average property, plant, and equipment = $4,163,980,000 $3,786,651,500 =1.10, where we use total operating revenues instead of sales and average property,
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plant, and equipment =($4,137,610,000 + $3,435,693,000) 2 =$3,786,651,500. Gross profit margin ratio (or gross profit ratio) = Gross profit margin Sales. Again, because Southwest Airlines is a service company and gross profit margin is not reported, this ratio is not computed. Total operating expense ratio = Total operating expense Total revenues = $3,480,369,000 $4,163,980,000 = 0.8358, or 83.58%. Salaries, wages, and benefits expense ratio = Salaries, wages, and benefits expense Total revenues = $1,285,942,000 $4,163,980,000 = 0.3088 or 30.88%. b. Return on Common Equity (ROCE). Compute Southwest Airlines’ 1998 ROCE using the reduced form of the ratio introduced in the module. Next, compute ROCE a second time using its ROA, common earnings leverage ratio, and capital structure leverage ratio components. Answer ROCE (reduced form) = (Net income - Preferred stock dividends) Average common stockholders' equity = ($433,431,000 - 0 ) $2,203,468,000 = 19.67%, where average common stockholders' equity = ($2,397,918,000 + $2,009,018,000) 2 = $2,203,468,000. ROCE (component parts) = ROA x Common earnings leverage ratio x Capital structure leverage ratio = [(Net income + Interest expense, net of income taxes) Average total assets] x [(Net income Preferred stock dividends) (Net income + (1 - t) Interest expense)] x [Average total assets Average common stockholders' equity] = 10.43% (see part a) x [($433,431,000 - 0 ) ($433,431,000 + ($56,276,000 (1-0.4))] x [$4,481,078,000 $2,203,468,000] = 10.43% x .9277 x 2.0336 = 19.68%, where average total assets = ($4,715,996,000 + $4,246,160,000) 2 = $4,481,078,000 and average common stockholders' equity = ($2,397,918,000 + $2,009,018,000) 2 = $2,203,468,000. (Note the two ROCE amounts are 0.01% different due to rounding.) c. Price/Earnings (PE) Ratio. Southwest Airlines’ 1998 high stock price was $23.75 per share; its low stock price was $15.31. Using 1998 EPS as your frame of reference what was the range of PE ratios at which the stock sold during the year? Answer Price/Earnings Ratio (high) = Stock price per share EPS = $23.75 $1.30 = 18.27, or 18.27 times earnings using basic EPS in the denominator. Using diluted EPS, the PE ratio =$23.75 $1.23 = 19.31. Price/Earnings Ratio (low) = $15.31 $1.30 = 11.78, or 11.78 times earnings using basic EPS and $15.31 $1.23 = 12.45 using diluted EPS. d. Short-term Liquidity Ratios. Compute Southwest Airlines’ 1998 current ratio, quick ratio, and accounts payable turnover ratio. Indicate which of the ratios generally would not be computed for
service companies.
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Module A
Answer Current ratio = Current assets Current liabilities = $574,155,000 $850,653,000 = 0.67. Quick ratio = Quick assets Current liabilities = (Cash and cash equivalents + Marketable securities + Receivables) Current liabilities = ($378,511,000 + $0+ $88,799,000) $850,653,000 = 0.55. Accounts payable turnover ratio = Purchases Average accounts payable. As a service company, Southwest Airlines has no inventory; therefore, this ratio is inappropriate. e. Long-term Solvency Ratios. Compute Southwest Airlines’ 1998 ratios for long-term debt to equity, long-term debt to total assets, interest coverage, operating cash flow to total liabilities, and operating cash flow to capital expenditures. For long-term debt, use only the long-term debt category instead of total noncurrent liabilities. Answer Long-term debt to equity ratio = Long-term debt Shareholders' equity =$623,309,000 $2,397,918,000 = 0.2599, or 25.99%. Long-term debt to total assets ratio = Long-term debt Total assets =$623,309,000 $4,715,996,000=0.1322, or 13.22%. Interest coverage ratio = (Income before income taxes + Interest expense) Interest expense = ($705,112,000 + $56,276,000) $56,276,000 = 13.53. Operating cash flow to capital expenditures ratio = Operating cash flow Capital expenditures = $886,135,000 $947,096,000 = 0.9356, or 93.56%. Operating cash flow to total liabilities ratio = Operating cash flow Average total liabilities = $886,135,000 $1,418,027,000 = 0.6249, or 62.49%, where average total liabilities = ($1,467,425,000 + $1,368,629,000) 2 = $1,418,027,000. 2. Compute Ratios for Texas Instruments. The complete 1998 GAAP financial statements for Texas Instruments are presented at our Web site (http://baginski.swcollege.com). Use these statements to calculate the following ratios. Note: The financial statements report amounts in millions, except per
share amounts.
a. Return on Assets (ROA) and Related Ratios. Compute Texas Instruments’ 1998 ROA using the overall ratio definition introduced in the text. Next, compute ROA a second time using the net profit margin ratio and asset turnover ratio components. Finally, compute Texas Instruments’ 1998 ratios for accounts receivable turnover, inventory turnover, fixed asset turnover, and gross margin. Texas Instruments breaks down operating expenses into only three categories on the income statement. Compute the total operating costs and expenses ratio (total operating costs and expenses net revenues) and the marketing, general, and administrative expense ratio (marketing, general, and administrative expense total operating revenue). On the income statement, Texas
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Instruments has the category interest on loans. Use that category as interest expense. Use an effective tax rate of 34.0%. Answer. Note: Answers are expressed in millions, except percentages and per share amounts, as presented on TI’s financial statements. ROA (overall ratio) = (Net income + Interest expense, net of income taxes) Average total assets = ($407+$75 (.66) ) $11,049.5= 4.13%, where average total assets =($11,250 + $10,849) 2 =$11,049.5. ROA (using component parts) = Net profit margin ratio x Asset turnover ratio = [(Net income + (1 - t) Interest expense) / Sales] x (Sales / Average total assets) = [$407+($75 x 0.66) / $8,460] x ($8,460 / $11,049.5) = 5.3960% x 0.7656= 4.13%, where we use net revenues instead of sales and average total assets = ($11,250 + $10,849) / 2 =$11,049.5. Accounts receivable turnover ratio = Sales Average accounts receivable = average accounts receivable = $8,460 $1,524 = 5.55, where we use net revenues instead of sales and average accounts receivable = ($1,343 + $1,705) 2 = $1,524. Inventory turnover ratio = Cost of goods sold Average inventory = $5,394 $669 = 8.06, where cost of goods sold is replaced by cost of revenues and average inventory = ($596 + $742) 2 = $669. Fixed asset turnover ratio = Sales Average property, plant, and equipment = $8,460 $3,776.5 = 2.24, where we use total operating revenues instead of sales and average property, plant, and equipment =($3,373 + $4,180) 2 =$3,776.5. Gross profit margin ratio (or gross profit ratio) = Gross profit margin Sales = $3,066 $8,460 = 0.3624, or 36.24%, where gross profit = net revenues of $8,460 - cost of revenues of $5,394 = $3,066. Total operating costs and expenses ratio = Total operating expense Total revenues = $8,061 $8,460 = 0.9528, or 95.28%. Marketing, general and administrative expense ratio= Marketing, general and administrative expense Total revenues = $1,461 $8,460 = 0.1727, or 17.27%. b. Return on Common Equity (ROCE). Compute Texas Instruments’ 1998 ROCE using the reduced form of the ratio introduced in the module. Next, compute ROCE a second time using the ROA, common earnings leverage ratio, and capital structure leverage ratio components. Answer. Note: answers are expressed in millions, except percentages and per share amounts, as presented on TI’s financial statements. ROCE (reduced form) = (Net income - Preferred stock dividends) Average common stockholders' equity = ($407 - 0 ) $6,220.5 = 6.54%, where average common stockholders' equity = ($6,527 + $5,914) 2 = $6,220.5.
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Module A
ROCE (component parts) = ROA x Common earnings leverage ratio x Capital structure leverage ratio = [(Net income + Interest expense, net of income taxes) Average total assets] x [(Net income Preferred stock dividends) (Net income + (1 - t) Interest expense)] x [Average total assets Average common stockholders' equity] = 4.13% (see part a) x [($407 - 0 ) ($407+($75 x 0.66))] x [$11,049.5 $6,220.5] = 4.13% x 0.8916 x 1.7763 =6.54%, where average total assets =($11,250 + $10,849) 2 =$11,049.5 and average common stockholders' equity = ($6,527 + $5,914) 2 = $6,220.5. c. Price/Earnings (PE) Ratio. Texas Instruments’ 1998 high stock price was $90.44 per share; its low stock price was $40.25. Using 1998 EPS as your frame of reference, what was the range of PE ratios at which the stock sold during the year? Answer. Note: Answers are expressed in millions, except percentages and per share amounts, as presented on TI’s financial statements. Price/Earnings Ratio (high) = Stock price per share EPS = $90.44 $1.04 = 86.96, or 86.96 times earnings using basic EPS. If diluted EPS is used, the PE ratio = $90.44 $1.02 = 88.67. Price/Earnings Ratio (low) = $40.25 $1.04 = 38.70, or 38.70 times earnings using basic EPS and =$40.25 $1.02 = 39.46 time earnings using diluted EPS. d. Short-Term Liquidity Ratios. Compute Texas Instruments’ 1998 current ratio, quick ratio, accounts receivable turnover ratio, inventory turnover ratio, and accounts payable turnover ratio. Answer. Note: answers are expressed in millions, except percentages and per share amounts, as presented on TI’s financial statements. Current ratio = Current assets Current liabilities = $4,846 $2,196 = 2.21 Quick ratio = Quick assets Current liabilities = (Cash and cash equivalents + Short-term investments + Receivables) Current liabilities = ($540 + $1,709 + $1,343) $2,196 =1.64. Accounts receivable turnover ratio = Sales Average accounts receivable = $8,460 $1,524 = 5.55, where net revenues is used for sales and average accounts receivable = ($1,343 + $1,705) 2 = $1,524. Inventory turnover ratio = Cost of goods sold Average inventory = $5,394 $669 = 8.06, where cost of revenues is used for cost of goods sold and average inventory = ($596 + $742) 2 = $669. Accounts payable turnover ratio = Purchases Average accounts payable = $5,248 $1,832 = 2.86, where purchases is approximated as Ending inventories + Cost of goods sold - Beginning inventories = $596 + $5,394 - $742 = $5,248, and Average accounts payable = ($1,582 + $2,082) 2 = $1,832. (We are compelled to use TI’s accounts payable and accrued expenses category because accounts payable is not separately presented.) e. Long-term Solvency Ratios. Compute Texas Instruments’ 1998 ratios for long-term debt to equity,
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long-term debt to total assets, interest coverage, operating cash flow to total liabilities, and operating cash flow to capital expenditures. For long-term debt, use the long-term debt amount from TI’s balance sheet, and do not use total noncurrent liabilities. Answer. Note: Answers are expressed in millions, except percentages and per share amounts, as presented on TI’s financial statements. Long-term debt to equity ratio = Long-term debt Shareholders' equity =$1,027 $6,527 = 0.1573, or 15.73%. Long-term debt to total assets ratio = Long-term debt Total assets =$1,027 $11,250=0.0913, or 9.13%. Interest coverage ratio = (Income before income taxes + Interest expense) Interest expense = ($617 + $75) $75 = 9.23. Operating cash flow to capital expenditures ratio = Operating cash flow Capital expenditures = $1,251 $1,031 = 1.213, or 121.3%. Operating cash flow to total liabilities ratio = Operating cash flow Average total liabilities $1,251 $4,829 = 0.2591, or 25.91%, where average total liabilities = ($4,723 + $4,935) 2 = $4,829. CFA Exam-Type Problems Answers only (see text for problems): 4. c Increasing the current ratio (current assets current liabilities) can be accomplished in three ways: (1) reducing the denominator without changing numerator, (2) increasing the numerator without changing denominator, and (3) if the current ratio is greater than 1.0, decreasing both the numerator and denominator by the same amount. Answer (b) does not affect current assets or current liabilities; so, it is incorrect. Answer (d) does not change the amount of current assets (or current liabilities); therefore, it is not correct. Delaying the next payroll would cause wages payable to increase with no change in assets, which would decrease the current ratio. Thus, answer (a) is incorrect. Answer (c) is a correct statement because the current ratio before the transaction, 1.5, is greater than the previous ration of 1.0. 5. c The current ratio is a measure of short-term liquidity risk, and both the interest coverage ratio and debt to equity ratio are measures of long-term solvency risk. Answer (c) is correct because ROA is a measure of profitability.
6. d Items (a), (b), and (c) are all sources of accounting quality. The lack of earnings manipulation is not a source of accounting quality; therefore, answer (d) is the correct answer. 7. Refer to Table 1 below. Calculate the ratios listed below for Disney as of September 30, 1993 (use ending balance sheet amounts). Briefly explain the use of each ratio in evaluating a company’s operations. (CFA adapted, with slight modification by authors)
10 a. b. c. d. Average number of days receivables are outstanding Cash flow from operations ratio Debt to capital (with equity at market) Times interest earned (interest coverage)
Module A
SEE THE TEXTBOOK FOR THE FINANCIAL STATEMENTS USED IN THIS PROBLEM. Answer. The following answer was supplied by the AIMR for this question. NOTE TO STUDENTS: Students who take the CFA exam are provided with pre-exam materials that define various financial statement ratios. Those ratios are then used in CFA answers. For example, part (d) of the question asks you to compute times interest earned (interest coverage). Times interest earned (interest coverage) was defined in the CFA exam study materials as Earnings before interest and taxes Interest. Note that the numerator used in Module A is income before income taxes plus interest expense. These two definitions result in the same numerator. It is not important whether your answers exactly match the CFA study guide answers. What is important is that you see what types of questions are asked and what knowledge is assumed. If you take the CFA exam, you will study a set of ratios and their definitions in advance, and you will use those when taking the CFA exam. An important lesson to be learned here is that because ratios can be computed in different ways, it is risky to take ratios computed by some other source and use them without know exactly how the ratios were computed. Because the AIMR and the text use different ratio definitions, the following answer will not correspond exactly to those you calculated using the text definitions. a. Average number of days receivables are outstanding. Average number of days receivables are outstanding = 365 days (Sales Receivables = 365 (8,529 1,390) = 59.5 days. The average number of days receivables are outstanding ratio measures the relationship between the firm’s level of activity and the assets needed to sustain that activity. The lower the number of days, the more efficient the firm’s operations. Monitoring the trend in the ratio over time or in comparison with other firms can pinpoint trouble spots or opportunities. b. Cash flow from operations ratio. Cash flow from operations ratio = Cash flow from operations Current liabilities = 2,145 2,821 = 0.76 times. The cash flow from operations ratio is a liquidity measure. The higher the ratio, the better. This ratio, as opposed to a static analysis (e.g., current or quick ratio) helps to assess a firm’s ability to operate as a going concern. c. Debt to capital (with equity at market). Although debt in the debt-to-capital ratio can be computed in several ways, equity is defined at market. Measuring equity at market is useful because it eliminates book value accounting distortions. In addition, a high market valuation implies that investors view the firm’s outlook positively. Equity at market = shares outstanding x market price per share = $544 million x 37.75 = $20,536 million. Debt can be defined comprehensively as total debt, which = current liabilities + borrowings + other
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liabilities = $2,821 million + $2,386 million + $1,514 million = $6,721 million. Alternatively debt = total liabilities and stockholder equity less equity (at book value) = $11,751 million - $5,030 million = $6,721 million. Other definitions of debt. Debt could be only current and long-term, which = $2,821 million + $2,386 million = $5,207 million. Debt could also be defined as borrowing plus other liabilities, which = $2,386 million + $1,514 million = $3,900 million. Alternatively, debt could be strictly long-term borrowings, which = $2,386 million. The debt-to-capital ratio is debt (appropriately defined) (debt + equity at market). Using the various definitions of debt, the debt-to-capital ratio: 1. = $6,721 million ($6,721 million + $20,536 million) = 24.66% 2. = $5,207 million ($5,207 million + $20,536 million) = 20.23% 3. = $3,900 million ($3,900 million + $20,536 million) = 15.96% 4. = $2,386 million ($2,386 million + $20,536 million) = 10.41% The debt-to-capital ratio measures the degree of a firm’s financial leverage. The higher the ratio, the riskier the firm’s position and the less flexibility the firm will have to withstand adversity. d. Times interest earned (interest coverage). Times interest earned (interest coverage) = Earnings before interest and taxes Interest = EBIT Interest = ($1,074 million + $158 million) $158 million = 7.80 times. The times interest earned ratio indicates the degree of protection available to creditors by measuring the extent to which earnings meet or “cover” interest costs.