|Author||Topic: A debt ratio question|
|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. 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).