Question

Picasso Company is a wholesale distributor of packaging equipment and supplies. The company’s sales have averaged about \(900,000 annually for the 3-year period 2015–2017. The firm’s total assets at the end of 2017 amounted to \)850,000.

The president of Picasso Company has asked the controller to prepare a report that summarizes the financial aspects of the company’s operations for the past 3 years. This report will be presented to the board of directors at their next meeting.

In addition to comparative financial statements, the controller has decided to present a number of relevant financial ratios which can assist in the identification and interpretation of trends. At the request of the controller, the accounting staff has calculated the following ratios for the 3-year period 2015–2017.

	2015	2016	2017
Current ratio	1.80	1.89	1.96
Acid-test (quick) ratio	1.04	0.99	0.87
Accounts receivable turnover	8.75	7.71	6.42
Inventory turnover	4.91	4.32	3.42
Debt to assets ratio	51.0%	46.0%	41.0%
Long-term debt to assets ratio	31.0%	27.0%	24.0%
Sales to fixed assets (fixed asset turnover)	1.58	1.69	1.79
Sales as a percent of 2015 sales	1.00	1.03	1.07
Gross margin percentage	36.0%	35.1%	34.6%
Net income to sales	6.9%	7.0%	7.2%
Return on assets	7.7%	7.7%	7.8%
Return on common stockholders’ equity	13.6%	13.1%	12.7%

In preparation of the report, the controller has decided first to examine the financial ratios independent of any other data to determine if the ratios themselves reveal any significant trends over the 3-year period.

Instructions

b) In terms of the ratios provided, what conclusion(s) can be drawn regarding the company’s use of financial leverage during the 2015–2017 period?

Short answer

Financial leverage has clearly decreased during the last three years.

Step-by-step solution

Meaning of Financial Leverage

The use of debt to acquire extra assets or fund initiativesis known as financial leverage. Individuals or corporations borrow money to generate debt. Borrowers pledge lenders that they will repay their debts in full, including the principle and interest. Leverage is also known as trading on equity or financial leverage.

Conclusion regarding financial leverage

Financial leverage has clearly decreased during the last three years. This is frequently manifested by a constant decrease in the long-term debt to assets ratio and the debt to assets ratio.

Clearly, the decrease in debt as a component of this firm's capital structure is accounted for by a decrease in the firm's long-term commitment.

This decrease in leverage can be linked to the decrease in the return on common stock equity percentage. This viewpoint is supported by the fact that both net incomes to sales and return on assets have increased.