Capitalizing - leverage ratio please

EastCoastJ

Can some one please explain the effects of capitalizing as opposed to expensing.

How does this affect the leverage ratio?

Leverage = assets/equity

When capitalizing does your asset increase by the same amount as your equity?

(also when expensing, you reduce your net income... so does this reduce your equity by the same amount?)

sgupta0827

also could someone explain this in regards to assets = liabilities + equity

Ionutzakis

take a very simplified example of a company thats starts with $100 cash financed 50/50 with debt and equity

the beginning balance sheet is

assets - 100 (cash)

liabilities
debt - 50
equity - 50

assume the company generates revenue of $1000 during year 1, cost of sales $500, purchases new equipment for $100 (10 year useful life), no taxes, no interest expenses

case 1 - expense new eqpt

the income statement is
profit = 1000-500 - 100 = 400 which flows to equity. assuming all transactions are cash based, cash will increase by the same amount

the balance sheet becomes

assets - 500 (100 begng cash + 400 cash generated during year)

liabilities
debt 50
equity 450 (50 beginning equity + 400 retained earnings for the year)

leverage ratio = 500/450 = 1.11

case 2 - capitalize new eqpt (=> only charge $10 depreciation for the year)

the income statement is
profit = 1000-500 - 10 = 490 which flows to equity.

the increase in cash is still 400 as before since accounting treatment (capitalizing vs expensing) does not impact cash flow (technically different taxes will impact cash, but we ignore taxes for this example)

the balance sheet becomes

assets -
cash 500 (100 begng cash + 400 cash generated during year)
equipment 90 (100 less 10 of accumulated depreciation)
total assets 590

liabilities
debt 50
equity 540 (50 beginning equity + 490 retained earnings for the year)
total liab + equity = 590

leverage ratio = 590/540 = 1.09

generally, both assets and equity are higher under capitalization. but equity increases by a larger % compared to the increase in assets hence the leverage ratio is lower.

mnieman

perfect thanks v much for that

MythosHF

When yuo capitalize, you inicrease your assets and your NI, which increase Equity. with the accoutnign equation, A = L + E, so we know A>E. That means that when you capitalize an asset, the equity will change by a higher percent than assets. In the leverage ratio A/E, E changes by a higher percentage than A so the denominator has a bigger percent change, meaning it has a bigger weight on the ratio. This will decrease the ratio.

btcapital

Usually lower debt ratios (like d/e or d/a) are preferable. Im not fully sure if a lower leverage ratio is improving, although it would seem like it would be better if its the same rationale as the debt ratios. Then again, a lower leverage ratio leads to lower ROE and lower growth rate, which leads to lower stock price in DDM. I guess it may depend on what you mean by "better"? anyone have any thoughts?

JRossSter

In this case the D/E ratio is a better measure of a company's leverage than the leverage ratio itself. Technically, when you capitalize the leverage ratio doesn't really improve because you'll have to depreciate or amortize the asset in the later years. Recognition of something like an ARO, on the other hand, leads to a permanent increase in both the D/E and the leverage ratios because you have a growing liability.

homie

cokecan Wrote:
-------------------------------------------------------
> thanks,
>
> does improving the leverage ratio mean that the
> ratio goes lower?

YES !!