chapter where it analyzes Coke and Pepsi 2016
financial statements and calculate financial ratios. Assess the
impact of long-term debt on risk and return
Answer Template and Questions: no anonymous
answers please
no anonymous answers please
- Read Review The Debt Analysis Section In The Chapter Where It Analyzes Coke And Pepsi 2016 Financial Statements And Ca 1 (149.98 KiB) Viewed 54 times
- Read Review The Debt Analysis Section In The Chapter Where It Analyzes Coke And Pepsi 2016 Financial Statements And Ca 2 (147.86 KiB) Viewed 54 times
DEBT TO EQUITY RATIO To measure a company's risk, we often calculate the debt to equity ratio: Total Habilities Debt to equtty ratio Stockholders'equity Debt requires payment on specific dates. Failure to repay debt or the interest associated with the debt on a timely basis may result in default and perhaps even bankruptcy for a company. Other things being equal, the higher the debt to equity ratio, the higher the risk of bankruptcy. When a company assumes more debt, risk increases. Debt also can be an advantage. It can enhance the return to stockholders. If a company earns a return in excess of the cost of borrowing the funds, shareholders are provided with a total return page 465 greater than what could have been earned with equity funds alone. Unfortunately, borrowing is not always favorable. Sometimes the cost of borrowing the funds exceeds the returns they generate. This illustrates the risk-reward trade-off faced by shareholders. Have you ever ordered a Pepsi and then found out the place serves only Coke products? Amusement parks often have exclusive contracts for soft drinks. The official soft drink of Six Flags is Coca-Cola. Cedar Point used to serve only Pepsi products, but now also has an exclusive deal with Coca-Cola. Illustration 9–20 provides selected financial data for Coca-Cola and PepsiCo. ILLUSTRATION 9-20 Financial Information for Coca-Cola and PepsiCo SELECTED BALANCE SHEET DATA December 31, 2016 and 2015 ($ in millions) Coca-Cola PepsiCo 2016 2015 2016 2015 Total assets $87,270 $89,996 $74,129 $69,667 Total liabilities $64,050 $64,232 $62,930 $57,637 Stockholders' equity 23,220 25,764 11,199 12,030 Total liabilities and equity $87,270 $89,996 $74,129 $69,667
Net sales Cost of goods sold Gross profit Operating expenses Other income Interest expense Tax expense Net income INCOME STATEMENTS For the year ended December 31, 2016 ($ in millions) Coca-Cola PepsiCo $41,863 $62,799 16,465 28,209 25,398 34,590 16,772 24,805 243 110 733 1,342 1,586 2,174 $ 6,550 $ 6,379 Illustration 9-21 compares the debt to equity ratio for Coca-Cola and PepsiCo. ILLUSTRATION 9-21 Debt to Equity Ratio for Coca-Cola and PepsiCo Debt to Equity Ratio ($ in millions) Coca-Cola PepsiCo Total Liabilities $64,050 $62,930 Stockholders' Equity $23,220 $11,199 2.76 5.62 The debt to equity ratio is higher for PepsiCo. Debt to equity is a measure of financial leverage. Thus, PepsiCo has higher leverage than Coca-Cola. Leverage enables a company to earn a higher return using debt than without debt, in the same way a person can lift more weight with a lever than without it. page 466 Decision Point
Decision Point Accounting information Question Analysis Which company has higher leverage? Debt to equity ratio Debt to equity is a measure of financial leverage Companies with more debt will have a higher debt to equity ratio and higher leverage. PepsiCo is assuming more debt, and therefore its investors are assuming more risk. Remember, this added debt could be good or bad depending on whether the company earns a return in excess of the cost of borrowed funds. Let's explore this further by revisiting the return on assets introduced in Chapter 7. Recall that return on assets measures the amount of income generated for each dollar of assets. In Illustration 9–22 we calculate the return on assets for Coca-Cola and PepsiCo. Net income Return on assets = Average total assets ILLUSTRATION 9–22 Return on Assets for Coca-Cola and PepsiCo ($ in millions) Coca-Cola PepsiCo Net Income $6,550 $6,379 Average Total Assets $88,633* $71,898** II II II Return on Assets 7.4% 8.9% : *($87,270 + $89,99672 **($74,129 + $69,66772 Coca-Cola returns 7.4 cents for each dollar of assets, compared with 8.9 cents for PepsiCo. For both companies, the return on assets exceeds the cost of borrowing each company's borrowing rate is less 1. ... 10A TI ... 1..11. 1. -1 1.-.1.. -.1 .1...
a Coca-Cola returns 7.4 cents for each dollar of assets, compared with 8.9 cents for PepsiCo. For both companies, the return on assets exceeds the cost of borrowing each company's borrowing rate is less than 4%). Therefore, both companies increase their total return by borrowing at a low rate and then earning a higher return on those borrowed funds. This illustrates the power of leverage to increase a company's profits. This is especially true for PepsiCo because its return on assets is higher than Coca- Cola. However, if return on assets should fall below the rate charged on borrowed funds, PepsiCo's greater leverage will result in a lower overall return to shareholders. That's where the risk comes in. TIMES INTEREST EARNED RATIO Lenders require interest payments in return for the use of their money. Failure to pay interest when it is due may invoke penalties, possibly leading to bankruptcy. A ratio often used to measure this risk is the times interest earned ratio. This ratio provides an indication to creditors of how many times” greater earnings are than interest expense. A company's earnings (or profitability) provide an indication of its ability to generate cash from operations in the current year and in future years, and its cash that will be used to pay interest payments. So, the higher a company's earnings relative to its interest expense, the more likely it will be able to make current and future interest payments. At first glance, you might think we can calculate the times interest earned ratio as net income divided by interest expense. But remember, interest is one of the expenses subtracted in determining net income. So, to measure how many times greater earnings are than interest expense, we need to add interest expense back to net income. Similarly, because interest is deductible for income page 467 tax purposes, we also need to add back income tax expense to get a measure of earnings before the effects of interest and taxes. We compute the times interest earned ratio as Times interest Net Income + Interest expense + Tax expense earned ratio Interest expense To further understand why we need to add back interest expense and income tax expense to net income, assume a company has the following income statement: Income before interest and taxes Interest expense Income before taxes Income tax expense (25%) Net income $90,000 (10,000) 80,000 (20,000) $ 60,000
How many times greater is the company's earnings than interest expense? Is it 6.0 times greater (= $60,000 = $10,000)? No, it's 9.0 times greater (= $90,000 = $10,000). If current earnings provide an indication of the ability of a company to generate cash from operations in the current year and in future years, then a ratio of 9.0 suggests that the company will have plenty of cash available to pay current and future interest payments. Illustration 9-23 computes the times interest earned ratios for Coca-Cola and PepsiCo to compare the companies' ability to make interest payments. ILLUSTRATION 9-23 Times Interest Earned Ratio for Coca-Cola and PepsiCo . = Net Income + Interest Expense + Tax Expense $8,869 $9,895 ($ in millions) Coca-Cola PepsiCo Interest Expense $ 733 $1,342 Times Interest Earned Ratio 12.1 7.4 : Coca-Cola has a higher times interest earned ratio than PepsiCo, indicating Coca-Cola is better able to meet its long-term interest obligations. However, both companies exhibit strong earnings in relation to their interest expense, and both companies appear well able to meet interest payments as they become due. KEY POINT The debt to equity ratio is a measure of financial leverage. Taking on more debt (higher leverage) can be good or bad depending on whether the company earns a return in excess of the cost of borrowed funds. The times interest earned ratio measures a company's ability to meet interest payments as they become due.