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, Inc.    Timberland Forest, Inc.

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

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. Debt ratio

2. Times interest earned ratio

b. Calculate the following profitability ratios for the two companies. Discuss their profitability relative to one another.

1. Operating profit margin

2. Net profit margin

3. Return on total assets

4. Return on common equity

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?