Equity/Investment Leverage Measures-Financial Management

Question 1

Will the capitalization of a lease by the lessee increase or decrease the debt to equity and asset turnover ratios?
Debt to Equity Ratio Asset Turnover Ratio
Increase Increase
Increase Decrease
Decrease Increase
Decrease Decrease

Answer 1

Capitalization of a lease by a lessee results in the lessee recording an asset and a liability. The increase in a liability (debt), without a change in equity, will increase the debt to equity ratio. The results can be seen in the following example:

Debt = $200 = 2:1 + Lease $50 = $250 = 2.5:1
Equity $100 $100

A change from 2:1 to 2.5:1 is an increase in the debt to equity ratio. Since capitalization of a lease increases the assets of an entity, the asset turnover ratio will decrease. The results can be seen in the following example:

Net Sales = $600 = 3 times+ Lease $50 = $600 = 2.4 times
Assets $200 $250

A change from 3 times to 2.4 times is a decrease in the turnover ratio.

Question 2

Echo Company has a long-term, variable-rate note payable outstanding, for which it does not elect the fair value option. Early in its fiscal year, the interest rate on its note increased as a result of changes in the market.

What effect will the increase in interest rate on its note payable have on its net income for the fiscal year and on its debt to equity ratio at the end of its fiscal year (compared to no change in the interest rate)?
	  Net Income  	  Debt to Equity Ratio  
	 Increase 	 Increase 
	 Increase 	 Decrease 
	 Decrease 	 Increase 
	 Decrease 	 Decrease

Answer 2

Net Income Debt to Equity Ratio
Decrease Increase

The increase in the interest rate will increase Echo’s interest expense for the year and decrease it net income for the year. While the change in interest rate will not change the carrying value of the note payable, the decrease in net income for the year will result in lower retained earnings (than if the interest rate had not changed).
Since retained earnings is an element of equity, the debt to equity ratio will increase - there will be less equity relative to the same debt.

Question 3

Debt-paying ability of a company might be assessed using the “debt ratio” or the “debt to equity ratio” (among others). For each of these ratios, is the company’s debt-paying ability (debt position) better if the ratio is higher or lower?

Debt Ratio  	  Debt to Equity Ratio  
	 Higher  	 Higher  
	 Higher  	 Lower 
	 Lower 	 Higher  
	 Lower 	 Lower

Answer 3

The debt ratio measures the percentages of a company’s assets that are financed by total debt, both short-term and long-term. The calculation would be:

Debt ratio = Total Debt
Total Assets

The resulting percentage (which must be less than 1.00) shows the extent to which the company’s assets are financed by debt. The reciprocal percent (i.e., 1.00 - debt ratio) would be the percent of assets financed by owners’ equity. (Remember: Assets = Debt + Equity). The lower the existing debt ratio (level of debt relative to assets), the better the firm’s debt-paying ability (or position). The debt to equity ratio measures the relative amounts of financing provided by creditors and owners.
The calculation would be:

Debt to equity ratio = Total Debt
Total Owners’ Equity

The resulting percentage (which could be more or less than 1.00) shows the amount of resource financing provided by creditors relative to owners. The lower the existing debt to equity ratio (level of debt relative to owners’ equity), the better the firm’s debt-paying ability (or position). Therefore, the lower each of these ratios, the better the debt position of a company.