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We saw earlier that financial leverage results from the use of fixed-cost financing,
such as debt and preferred stock, to magnify return and risk. The amount of leverage in the firm’s capital structure can affect its value by affecting return and risk.
Those outside the firm can make a rough assessment of capital structure by using
measures found in the firm’s financial statements. Some of these important debt
ratios were presented in Chapter 2. For example, a direct measure of the degree of 436 PART 4 Long-Term Financial Decisions indebtedness is the debt ratio. The higher this ratio, the greater the relative
amount of debt (or financial leverage) in the firm’s capital structure. Measures of
the firm’s ability to meet contractual payments associated with debt include the
times interest earned ratio and the fixed-payment coverage ratio. These ratios
provide indirect information on financial leverage. Generally, the smaller these
ratios, the greater the firm’s financial leverage and the less able it is to meet payments as they come due.
The level of debt (...
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This document was uploaded on 03/30/2014.
- Spring '14