Explain why the volatility (i.e., instability) of a firm’s input and operating costs over time might be a critical factor in drawing conclusions about the adequacy of their debt coverage ratios. How...

1. Explain why the volatility (i.e., instability) of a firm‟s input and operating costs
over time might be a critical factor in drawing conclusions about the adequacy of
their debt coverage ratios.
A firm’s debt coverage ratio is calculated as Net operating income/total debt, which
shows the total amount of cash flow available to meet a firm’s debt obligations i.e.
both interest and principal payments. Firm’s input and operating costs are a key
determinant of its net operating income, i.e. sales remaining constant; increase in
input and operating cost can reduce the net operating income, while a decrease in
input and operating cost can increase the net operating income. Thus it will be very
difficult for a firm with fluctuating operating income to meet its debt obligations.
Generally the debt providers view the volatility of a firm’s cost with greater attention
as this will give them a clear idea of a firm’s ability to repay its debt in time. Thus
they will be more reluctant to give debt to firms with fluctuating operating and input
costs than to the firms with relatively stable input and operating costs.
2. How do the price/earnings (P/E) ratio and the market/book (M/B) ratio provide
a feel for the firm‟s riskiness as perceived by the investors who trade the firm‟s
stock?
P/E ratio can be defined as the dollar value paid for each dollar earning by a firm. A
higher P/E ratio could suggest that investors might be looking for a higher growth in
future earnings when compared to a company with lower P/E ratio. Thus the firm with
a higher P/E ratio compared to other peers in the similar industry if facing the risk of a
drop in share value if the firm is not able to generate adequate earnings growth.
Market/book ratio or (M/B) ratio is also referred to as the price to book ratio, which is
used to compare stock’s market value to its book value. It represents the value which
the market perceives of each dollar value of company’s tangible asset. Again if the
firm has a higher P/B compared to its peers in the industry, then it again faces
significant risk of non-performance in the future which could lead to decrease in stock
price.
3. Two firm‟s have the same ROA of 10%. Using the DuPont version of the ROA
equation explains a critical difference in how these two identical ROAs might
have been produced.
ROA or the return on assets is a measure of firm’s efficiency in using its assets to
generate each dollar in earnings. It is calculated as Net Income / Total Assets.
According to the DuPont version of ROA, the calculation can be broken into two
parts:
Net Profit margin * Asset turnover ratio,
(Net Income / Sales)*(Sales/Total Assets). Thus as per DuPont’s calculation ROA
results from the product of net profit margin and asset turnover ratio. Two identical
ROA can be produced in the following circumstances:
 Either one firm has a higher Net profit margin, and lower Asset turnover ratio
than the other
 Or, one firm has a lower net profit margin, and higher asset turnover ratio than
the other firm
So when two firms have identical ROA, it becomes very vital for the analysts or...