Ugh it reduces financing costs debt does carry

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- -. ugh it reduces financing costs, debt does carry default risk: the risk that the company will able to repay debt when it comes due. Creditors have several legal remedies when com- -es default, including forcing a company into bankruptcy and possibly liquidating its assets. During the past decade, the median ratio of total liabilities to stockholders' equity, which sures the relative use of debt versus equity in a company's capital structure, is about 1.5 for . ly traded companies with sales over $500 million. This means that the average company - anced with about $1.50 of liabilities for each dollar of stockholders' equity. However, the - ive use of debt varies considerably across industries as illustrated in Exhibit 3.6. ~ -~-- =xHIBIT3.6 Median Ratio of Liabilities-to-Equity for Selected Industries Debt-to-Equity Ratio
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Limitations of Ratio Analysis 3-19 Module 3 I Profitability Analysis and Interpretation Companies in the utilities industry have a large proportion of debt. Because the utilities industry is regulated, profits and cash flows are relatively certain and stable and, as a result, util- ity companies can support a higher debt level. The hotel and nondurable wholesale industries also utilize a relatively high proportion of debt. However, these industries are not regulated, their market is more competitive and volatile and, consequently, their use of debt carries more risk. At the lower end of debt financing are retail and restaurant companies. The core of our analysis relating to debt is the examination of a company's ability to generate cash to service its debt (that is, to make required debt payments of both interest and principal). Analysts, investors and creditors are primarily concerned about whether the company either has sufficient cash available or whether it is able to generate the required cash in the future to cover its debt obligations. The analysis of available cash and a company's ability to service its debt in the short run is called liquidity analysis. The analysis of the company's ability to generate suf- ficient cash in the long run is called solvency analysis (so named because a bankrupt company is said to be "insolvent"). The quality of financial statement analysis depends on the quality of financial information. We ought not blindly analyze numbers; doing so can lead to faulty conclusions and suboptimal deci- sions. Instead, we need to acknowledge that current accounting rules (GAAP) have limitations, and be fully aware of the company's environment, its competitive pressures, and any structural and strategic changes. This section discusses some of the factors that limit the usefulness of finan- cial accounting information for ratio analysis. GAAP Limitations Several limitations in GAAP can distort financial ratios. Limitations include: 1. Measurability. Financial statements reflect what can be reliably measured. This results in nonrecognition of certain assets, often internally developed assets, the very assets that are most likely to confer a competitive advantage and create value. Examples are brand name, a
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