Final answer:
It is true that financial ratios like Debt-to-Equity and Debt-to-Assets are best used to compare firms within the same industry due to differing capital structures and business practices. Equity is calculated as the difference between total assets and liabilities, reflecting the financial health of a business. Bonds are similar to bank loans in function, serving as a means of raising capital, but differ in their terms and repayment structures.
Step-by-step explanation:
The statement is true: Debt-to-Equity and Debt-to-Assets ratios usually provide a clear picture of the financial leverage employed by a firm, with the understanding that high levels of debt indicate high financial risk. However, this conclusion is best drawn when comparing firms within the same or very similar industries. Comparing firms across different industries can be misleading due to variability in industry practices, capital requirements, and business models. When firms decide on sources of financial capital, such as early-stage investors, reinvesting profits, borrowing through banks or issuing bonds, and selling stock, they choose both a method of financing and its associated costs.
A bond is similar to a bank loan in that both are ways for a firm to raise capital by borrowing. They differ in that a bond is a formal contract to repay borrowed money with interest at fixed intervals, while a bank loan is typically more flexible in terms and may have a different interest rate structure. Equity for an individual like Eva, who bought a house for $200,000 with a 10% down payment, would be her down payment, which is $20,000, assuming no change in the property value or additional payments were made.
In terms of a firm's equity, this can be understood through the T-account, which lists a firm’s assets on the left and liabilities on the right. Equity is the total assets minus total liabilities and is included on the liabilities side to ensure the T-account balances. A healthy business has positive net worth, while a bankrupt firm has negative net worth. In either situation, assets are always equal to liabilities plus net worth in a bank's T-account.