FINANCIAL
STATEMENT ANALYSIS 1-39
Generation of
sales by total asset
value
Like the Fixed Assets Turnover Ratio, this ratio gives the analyst an
indication of how well a company is utilizing its assets. The Total
Assets Turnover Ratio indicates how many times the value of all
A
SSETS
is being generated in
S
ALES
. The same concerns about
understated assets also are applicable to the Total Assets Turnover
Ratio.
Debt Management Ratios
Capital structure
mix of debt and
equity financing
As discussed earlier, a company can choose to raise part of its capital
in the form of equity (money from investors in the company) or in the
form of debt (money borrowed from creditors). Debt is generally less
expensive than equity, especially when tax issues are relevant (interest
payments often are tax-deductible, but dividends usually are not). A
company's "capital structure" refers to the mix of debt and equity that
is used to finance assets. Most companies seek an ideal capital
structure, one that maximizes the total value of the company.
Financial
leverage:
Use of debt
to capitalize
Financial leverage is the use of debt financing to raise capital for
operations and growth. The concept of financial leverage can be
explained with a short example.
Example
Consider a company wishing to grow and expand its operations. The
company believes that, with an additional $10 million in capital, it can
generate $40 million in net income in the coming year. The company
can find investors to invest $10 million in the company. However, at
the end of the year, the new investors will be entitled to a share of the
income, thus diluting the return to the original shareholders. If the
company borrows the $10 million, the company will simply pay the
interest on the loan (and the principal if the loan is due). The entire net
income, less the interest payment, will be available for the original
shareholders.