Hi guys, I cannot figure out why the correct answer is B to the question below. Bath & Books seems to be the most stable and financially sound out of them all. Therefore it should have a low debt ratio. Thanks in advance for your help. Which of the following firms is likely to have a higher debt ratio? A) Critter Care, which has a low debt rating due to the prior financial mismanagement by the chief executive officer. B) Bath & Books, which produces toiletries and other consumer staples that are in demand regardless of economic conditions. C) Egg Harbor Furs, which serves as a wholesaler of fine furs and garments. Your answer: A was incorrect. The correct answer was B) Bath & Books, which produces toiletries and other consumer staples that are in demand regardless of economic conditions. Bath & Books appears to have relatively little business risk, especially in relation to Egg Harbor Furs, which is likely to be a much more cyclical business. Creditors will be less willing to lend funds to Critter Care whose managers have shown poor money management skills in the past.
the answer explanation says all you need to know. Bath and Books is in a non cyclical industry, with stable profit/revennues/operations. You could argue it is a “safer” company, in other words there is less chance of default on its loans. This will make it easier for them to borrow money compared to the other two companies, so the debt ratio will be higher. In other words, sound and stable companies can access credit more easily than less stable companies, and can do so more cheaply as well (lower cost of debt).
I think the answer should be A.
Question probably has an error, and they mean debt rating, not ratio. B would be correct
debt rating as a term used in the question is fine. due to financial mismanagement - you would tend to think that the amount of debt (what is shown on the financial statement) is not right - so you would tend to increase the debt ratio. (Higher debt ratio is bad).
Spanishesk Wrote: ------------------------------------------------------- > the answer explanation says all you need to know. > > > Bath and Books is in a non cyclical industry, with > stable profit/revennues/operations. You could > argue it is a “safer” company, in other words > there is less chance of default on its loans. This > will make it easier for them to borrow money > compared to the other two companies, so the debt > ratio will be higher. > > In other words, sound and stable companies can > access credit more easily than less stable Concur with Spanish A financially mismanged firm is likely to have a lower debt ratio because lenders would not be sure of the finacials. Therefore, inclination to lend may be lower or at least temporarily firm may be locked out of debt market. > companies, and can do so more cheaply as well > (lower cost of debt).
I would tend to agree with C3Po and Spanishesk, and disagree with others. My thought process in reading the Q would be as follows… A) Critter Care, which has a low debt rating (**okay, this bodes well for it possibly having a high debt ratio and thus being the right answer, as a high debt ratio is certainly one factor that could lead to a low debt rating**) due to the prior financial mismanagement by the chief executive officer (**Okay, now I am thinking this is probably not the answer. If there was financial mismanagement in the recent past, it is most likely difficult for them to access debt markets to the extent necessary to build a high debt ratio**) B) Bath & Books, which produces toiletries and other consumer staples that are in demand regardless of economic conditions (**in demand regardless of economic conditions- certainly sounds like the kind of company that a)creditors would be willing to lend to and b)would be willing to take on large amounts of debt in proportion to its total capital, as it is not as likely as some other companies to suffer during downturns in the business cycle. I like this as the possible correct answer at this point**) C) Egg Harbor Furs, which serves as a wholesaler of fine furs and garments (**fine furs and garments, sounds like a pretty cyclical business. Based just on the information given, certainly not the kind of company that would be wanting to take on large amounts of debt. ESPECIALLY compared to the previous option, in which the company’s products were always in demand. Probably not the right answer**) So B sounds very good, A is possible but a bit iffy, and C I have ruled out. Go with B.
Consider A. Poor rating means, low gurantee of return of principal and interest. No info on business given - could be capital intensive or not. Rating might have been just revised. Mis-management might not be the main reason was poor rating. All these does not mean low debt ratio. Consider B. This company is selling non-discretionary goods; hence sales are more stable. Such companies generally do not have more long term debt and since sold goods have short life, have high turnover and they requrie more working capital i.e. short term debt intensive. Any lender would prefer to give long term debt to these companies but will they borrow? Generally not. Consider C: The company is indeed in cyclical business and is there a rule that they can’t borrow at all? This company would most likely match their revenues to meet debt payments. Meaning oscialltory debt but low one. Having known this, if we are to answer a firm that is ‘likely’ to have higher debt ratio - I am implying it as current status and not future. Secondly, when companies match their revenues for payment of debts we can rule out C. Between A and B, assuming that Debt = Short term + Long term, B could be right answer (purely because less info about nature of business of A)
Look at it from a financial standpoint. The company`s goal is to minimize it’s WACC. If the financials are sketchy and there has been mismanagement lenders are going to demand higher yields to lend money making debt a costly financing option. If the earnings are steady and not dependent on the economic cycle, there is a lower risk and the company can take on more debt at a lower cost.Hence this company can be expected to have a higher debt ratio.
The point they are trying to make is that companies in stable industries are more likely to have higher debt ratios due to their ability to borrow money. Not sure if this is true. I did a Google search for debt ratios by sector and did not find any evidence of what they are suggesting. Here is the link: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/dbtfund.htm