Question

Pl give me the explanation in 100 words at-least. I know the correct answer. Thanks

An analyst is evaluating two companies, A and B. Company A has a debt ratio of 50% and Company B has a debt ratio of 25%. In his report, the analyst is concerned about Company B's debt level, but not about Company A's debt level. Which of the following would best explain this position?
A) Company B has much higher operating income than Company A.
B) Company A has a lower times interest earned ratio and thus the analyst is not worried about the amount of debt.
C) Company B has a higher operating return on assets than Company A, but Company A has a higher return on equity than Company B.
D) Company B has more total assets than Company A.

Answer 1

When two companies are compared especially with amounts of debt between them, the primary differentiating factor between the two firms would be the coverages among them as to whether they have enough income to cover the interest payments. In the above case, despite A having higher debt ratio of 50% against the B's debt ratio of 25%, the analyst is concerned for B. The most likely reason for this concern is that company B has much higher operating income than A. The formula for interest coverage is (EBIT/Interest) and as B's EBIT is much higher than A, it is able to cover its interest at a much better manner than A whose EBIT is low. Thus, due to lower interest coverage, A could be at a risk of financial distress and bankruptcy if not managed well.

Answer is A) Company B has much higher operating income than Company A.