Which of the following statements is correct?
A)If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses.
B)If two firms differ only in their use of debt-i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates-but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales.
C)The debt ratio as it is generally calculated makes an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets are still comparable.
D)If two firms differ only in their use of debt-i.e., they have identical assets, sales, operating costs, and tax rates-but one firm has a higher debt ratio, the firm that uses more debt will have a higher profit margin on sales.

Question

Quizplus · Accepted Answer

The use of debt can increase the financial risk of a firm and thus lower its creditworthiness and increase its cost of borrowing. This can result in a lower profit margin for the firm using more debt, as it has to pay higher interest expenses. However, this effect may be mitigated or even reversed in some cases where the use of debt results in a higher return on equity, which can increase the profit margin. Therefore, statement B is the only one that accurately reflects the potential impact of debt on a firm's profit margin, holding other factors constant. Statements A and D are incorrect as the TIE ratio and profit margin may be affected by other factors such as the firm's operating income, interest expense, and tax rates, and the debt ratio alone cannot determine these ratios. Statement C is incorrect as operating leases are not counted as debt in the debt ratio calculation, and thus the debt ratios of firms with different lease percentages may not be comparable.

Which of the Following Statements Is Correct