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Cornerstones of Financial Accounti...

4th Edition
Jay Rich + 1 other
ISBN: 9781337690881

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Cornerstones of Financial Accounti...

4th Edition
Jay Rich + 1 other
ISBN: 9781337690881
Textbook Problem
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Evaluating Leverage

Gearing Manufacturing Inc. is planning a $1,000,000 expansion of its production facilities. The expansion could be financed by the sale of $1,250,000 in 8% notes or by the sale of $1,250,000 in common stock, which would raise the number of shares outstanding from 50,000 to 75,000. Gearing pays income taxes at a rate of 30%.

Required:

4. As an investor, how would you use accounting information to evaluate the risk of excessive use of leverage? What additional information would be useful? Explain.

To determine

Concept introduction:

Debt to Equity Ratio:

Debt to equity ratio is calculated to determine the leverage position of the company. It compares the total liabilities of the company with it total shareholders’ equity. The debt to equity ratio is calculated by dividing the Total Liabilities by Total Stockholder’s Equity. The formula to calculate Debt to equity ratio is as follows:

Debt to equity ratio = Total liabilitiesTotal Stockholder’s Equity

Basic Earnings per share:

The Basic Earnings per share is the amount of net income earned by each common share outstanding. The Earnings per share calculated by with help of following formula:

Basic Earnings per share=Net Income - Preferred DividendWeighted Average Common Shares Outstanding

 Net Income available to common stockholder = Net income  Preferred Dividend

To indicate:

The additional information for an investor.

Explanation

Debt to equity ratio is calculated to determine the leverage position of the company. It compares the total liabilities of the company with it total shareholders’ equity. The debt to equity ratio is calculated by dividing the Total Liabilit...

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