Question

Debt ratio and equity ratio added together must equal ____?

Answer 1

The sum of the debt ratio and equity ratio must equal 1, but in the provided example, the calculation yields an unexpected result of 2.54, likely due to an error in the provided financial balances.

Step-by-step explanation:

The debt ratio and equity ratio reflect a company's financial leverage and are components that detail the proportion of assets financed by debt and equity. The sum of these two ratios must equal 1 (or 100% when expressed as percentages), indicating that all assets are financed either by debt or equity.

To calculate these ratios using the provided information, we first define each term: the debt ratio is the proportion of a company's assets financed by its debt, and the equity ratio is the proportion financed by shareholders' equity. In this example, the total assets are 130 (30 in reserves, 50 in bonds, and 50 in loans) and the total equity is 30. Thus, the debt ratio is calculated as the total liabilities (300 in deposits) divided by total assets (130), and the equity ratio as total equity (30) divided by total assets (130).

The debt ratio is 300/130 and the equity ratio is 30/130. When added together, (300/130) + (30/130), they simplify to 330/130, which equals 2.54. This result is unexpected, as typically the sum of the debt ratio and equity ratio should equal 1. The discrepancy is likely due to an error in the provided balances, as liabilities and equity together should always equal total assets for the balance sheet to be in equilibrium.

Answer 2

Debt ratio and equity ratio added together must equal 1.

Step-by-step explanation:

The debt ratio and equity ratio are financial metrics used to assess a company's capital structure, representing the proportion of debt and equity in its financing. The sum of these two ratios must equal 1, as they encompass the entirety of a company's capital. The debt ratio is calculated by dividing total debt by total assets, and the equity ratio is determined by dividing total equity by total assets. Therefore, the sum of these ratios provides a comprehensive picture of how a company has financed its assets.

Mathematically, this relationship can be expressed as follows:

`\[ \text{Debt Ratio} + \text{Equity Ratio} = \frac{\text{Total Debt}}{\text{Total Assets}} + \frac{\text{Total Equity}}{\text{Total Assets}} = \frac{\text{Total Debt} + \text{Total Equity}}{\text{Total Assets}} \]`

For example, if a company's debt ratio is 0.4, indicating that 40% of its assets are financed through debt, the equity ratio would be \(1 - 0.4 = 0.6\), or 60%. The sum of these ratios (0.4 + 0.6) equals 1, signifying that the company's assets are entirely financed either through debt or equity. This equilibrium is crucial for understanding a company's financial health and risk profile, as a balanced capital structure is often associated with stability and strategic financial management.