LESSON OUTLINE

1. Introduction to Financial Management

2. Review of Financial Statement Preparation, Analysis, and
Interpretation
3. Financial Planning Tools and Concepts
4. Sources and Uses of Short-Term and Long-Term Funds
5. Basic Long-term Financial Concepts
6. Introduction to Investment
7. Managing Personal Finance
Review of Financial Statement
Preparation, Analysis,
Interpretation 6
 Learning Objectives:

At the end of this lesson, the learners will be able to:

• Define financial leverage.

• Solve leverage ratios (debt ratio, debt-to-equity ratio, interest coverage
ratio).
• Analyze, interpret, and compare the leverage ratios of sample companies.
:
• What is the difference between an income statement and a balance sheet
and what relevant accounts (liabilities, assets, equity, interest expense,
earnings before interest and taxes) mean.
• What is meant by the statement that income statement represents a
period of time or the movement through that period while the
balance sheet represents amounts as of a point in time.

Motivation (10 MINS):

1. How do you think one opens his own business? What if he does not have
capital or personal money ready to start a business?
2. He will most likely borrow from friends, family, and banks. What do you
think these borrowings would entail?
3. How do you think paying interest affects the earnings of the company.
Financial Leverage Definition
• Financial leverage refers to the company’s use of debt. It defines the
company’s capital structure which indicates how much of the total assets
are financed by debt and equity.

Example:
• Pam has a small restaurant business with current equity of PHP50,000.
• With the increasing demand, she is planning to expand her restaurant
space.
• After much analysis she determined that an initial investment of PHP50,000
in fixed assets is necessary.
• These funds can be obtained in either of two ways.
• The first, is the no-debt plan, under which she would ask a relative to
become an investor (owner) by investing the full PHP50,000.
• The other alternative, the debt plan, involves borrowing PHP50,000 from
the nearby rural bank at 10% annual interest.
• Pam expects PHP 30,000 in annual sales, PHP18,000 in operating expenses,
and a 30% tax rate.
Example:
• The no-debt plan results in after-tax profits of PHP8,400, which is an 8.4%
return on equity (new equity of PHP100,000).
• The debt plan results in PHP4,900 of after-tax profits or 9.8% return on
equity (equity still at PHP50,000). The debt plan provides Pam with a higher
rate of return, but the risk of this plan is also greater, because the annual
PHP5,000 of interest must be paid whether Pam’s business is profitable or
not.”

Leverage Ratios Definition and Formulas:

• Debt ratio
– This ratio measures the proportion of total assets finance by total
liabilities or money
provided by creditors (not by the business owners).
Leverage Ratios Definition and Formulas:
• Debt-to-equity ratio – A variation of debt ratio, shows the proportion of
debt to equity.

• Interest coverage ratio – This ratio shows the company’s ability to pay
its fixed interest charges in relation to its operating income or earnings
before interest and taxes. Another name of interest coverage ratio is Times
Interest Earned.
• What factors influence capital structure, therefore
affects leverage ratios. The following are just some of
the factors that can influence management’s decision in
setting its capital structure.

 Prospects of the industry

– A growing industry makes business more confident to take on
more
financial risk.
 Taxes
- Interest expenses are tax deductible while cash dividends are
not. By
having more debt than equity, businesses save on taxes as
interest
expense (multiplied by the tax rate) decreases income tax
due.
• What factors influence capital structure, therefore
affects leverage ratios. The following are just some of
the factors that can influence management’s decision in
setting its capital structure.

 Nature of Business
– If the business is risk then it has to be financed
conservatively hence,
lower debt ratio.
 State of Business Development
– A newly formed business may have difficulty borrowing from
banks.
Banks usually look for the historical financial performance of
borrowers.
 Macroeconomic conditions
– If the overall economy is good then management can be more
Compute for the Leverage Ratios from ample Sample financial statements
below:
PRACTICE (20 MINUTES)
Provide exercises. Here is a sample question:
1. (Easy) Total assets is 100,000. Total debt is 50,000. What is the
debt-to-equity ratio?
2. (Average/Difficult) If the pro forma balance sheet shows that
total asset increase by PHP400,000
while retaining a debt-equity ratio of .75 then:
A. debt must increase by PHP300,000.
B. equity must increase by the full PHPH400,000.
C. debt must increase by PHP171,428.
D. equity must increase by PHP100,000.
ENRICHMENT (20 MINUTES)
1. Summarize and recap the relationship of the accounts in
computing the ratios.

2. Discuss what you think the ratios mean and its applications.
Reflect on
the following questions:
• What is a good capital structure?
• Are low debt ratios always favorable?
3. The condensed financial statements of the three companies as of December 31, 2014 are as shown below.

• Note: Included in the 2014 Income Statement of the three companies are Interest Expenses:
1. Compute the ratios of the sample companies and compare the three
companies using the ratios computed. Recall other relevant ratios like return
on equity in highlighting how leverage magnifies risk and return in
companies.
2. What are the possible reason why the sample companies have debt ratios.
• Note: Included in the 2014 Income Statement of the three companies are
Interest Expenses:

4. Ask the learners to compute the ratios of the sample companies and ask
them to compare the three companies using the ratios computed. Recall
other relevant ratios like return on equity in highlighting how leverage
magnifies risk and return in companies.
5. Ask the learners the possible reason why the sample companies have debt
ratios.
Answers will mostly focus on the selected companies’ nature of business,
management style/preference, stability of cash flows.
THANK YOU!!!
EVALUATION (20 MINUTES)
1. Provide a written true-or-false or multiple-choice quiz similar to
the Practice exercises above.
2. Include an essay question in the quiz. Possible questions would
be:
• In starting a business, is it okay to start with having debt during
the early stages?
• What dictates the company’s choice of leverage structure?