Karson Transport Company Financial Ratios Analysis ✓ Solved
Karson Transport Company Financial Ratios Analysis
The Karson Transport Company currently has a net operating income of $493,000 and pays interest expenses of $203,000. The firm plans to borrow $1.18 million at an interest rate of 10% to finance an investment expected to increase net operating income by $405,000 annually. This analysis aims to evaluate the company's financial leverage and its impact on the times interest earned (TIE) ratio before and after the new borrowing and investment.
Introduction
The times interest earned ratio, also known as the interest coverage ratio, measures a company's ability to meet its interest obligations from its operating income. A higher ratio indicates greater financial stability and lower risk for creditors. Assessing this ratio before and after new debt issuance provides insights into the company's financial health and its capacity to handle additional leverage.
Part A: Calculation of the Current Times Interest Earned Ratio
Initially, the company's current times interest earned ratio is calculated using the existing net operating income and interest expenses. The formula is:
TIE = Net Operating Income / Interest Expense
Substituting the provided values:
TIE = $493,000 / $203,000 ≈ 2.43 times
This indicates that before any additional borrowing or investment, Karson Transport can cover its interest payments approximately 2.43 times with its current operating income.
Part B: Effect of the Loan and Investment on the Times Interest Earned Ratio
Post-borrowing, the company's interest expense will increase due to the new debt. The additional interest cost from the $1.18 million loan at 10% interest is calculated as:
Additional interest = $1,180,000 × 10% = $118,000
Therefore, the total interest expense becomes:
Total interest = $203,000 + $118,000 = $321,000
The new net operating income will be the current income plus the expected increase from the investment:
New net operating income = $493,000 + $405,000 = $898,000
Now, the new times interest earned ratio is computed as:
TIE = $898,000 / $321,000 ≈ 2.80 times
This increase from 2.43 to approximately 2.80 times suggests that the company's ability to cover interest payments improves, despite increased debt. The enhanced operating income more than compensates for the higher interest expenses, indicating a strengthened financial position post-investment.
Conclusion
Before the new debt and investment, Karson Transport's times interest earned ratio was approximately 2.43 times, reflecting a moderate cushion to meet its interest obligations. After borrowing and investing, the ratio increases to roughly 2.80 times, indicating improved coverage and financial stability. This analysis underscores the importance of leveraging strategic investments to enhance company profitability without compromising creditworthiness.
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