Question

If a firm has a debt-equity ratio of 1.0, then its total debt ratio must be which one of the following?

1) 0.5
2) 1.0
3) 2.0
4) Cannot be determined

Answer 1

A firm with a debt-equity ratio of 1.0 will have a total debt ratio of 0.5, since the total assets will be twice the amount of the total debt, and the ratio of total debt to total assets simplifies to 0.5. Therefore correct option is A

Step-by-step explanation:

Understanding Financial Ratios

When a firm has a debt-equity ratio of 1.0, it means the firm's total debt is equal to its total equity. However, the total debt ratio differs from the debt-equity ratio. The total debt ratio is calculated by dividing total debt by total assets.

Given a debt-equity ratio of 1.0, this implies total debt equals total equity. Let's consider the equation for the debt-equity ratio, which is total debt divided by total equity.

For a ratio of 1.0, if total debt is 'D' and total equity is 'E', then D = E. The total assets 'A' would be the sum of debt and equity, so A = D + E. With a 1:1 ratio for debt to equity, A = 2D. The total debt ratio is then D/A.

So, that would be D/(2D), which simplifies to 1/2 or 0.5.

Therefore, if a firm's debt-equity ratio is 1.0, its total debt ratio must be 0.5.