Professional Documents
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Firms are financed by some combination o debt and equity. The right capital
structure will depend on tax policyhigh corporate rates favor debt, high personal tax
rates favor equityon bankruptcy costs, and on overall corporate risk. In particular,
if we are concerned about bankruptcy possibilities, the long-run solvency
or leverage of the firm may be important. There are two commonly used measures of
leverage, the debt-to-assets ratio and the debt-equity ratio;
Debt-to-asset ratio = total liabilities / total assets
Debt-equity ratio = long-term debt / shareholder's equity
As with liquidity measures, problems in measurement and interpretation also
occur in leverage measures. The central problem is that assets and equity are typically
measured in terms of the carrying (book) value in the firm's financial statements. This
figure, however, often has very little to do with the market value of the firm, or the
value that creditors could receive were the firm liquidated.
Debt-to-equity ratios vary considerably across industries, in large measure due
to other characteristics of the industry and its environment. A utility, for example,
which is a stable business, can comfortably operate with a relatively high debt-equity
ratio. A more cyclical business, like manufacturing of recreational vehicles, typically
needs a lower D/Ea reminder that cross-industry comparisons of these ratios is
typically not very helpful.
Often, analysts look at the debt-equity ratio to determine the ability of an
organization to generate new funds from the capital market. An organization with
considerable debt is often thought to have little new-financing capacity. Of course,
the overall financing capacity of an organization probably has as much to do with the
quality of the new product the organization wishes to pursue as with its financial
structure. Nevertheless, given the threat of bankruptcy and the attendant costs, a very
high debt-equity ratio may make future financing difficult. It has been argued, for
example, that railroads in the 1970s found it hard to find funds for new investments in
piggybacking, a large technical improvement in railroading, because the threat of
bankruptcy from prior poor investments was so high.
RATES OF RETURN
There are two measures of profitability common in the financial community,
return on assets (ROA) and return on equity (ROE).
ROA = net income / total average assets