Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

II. Financial Statements

and Long−Term Financial

Planning

3. Working with Financial
   Statements

(^98) © The McGraw−Hill
Companies, 2002
Total debt ratio 
.28 times

[3.6]

In this case, an analyst might say that Prufrock uses 28 percent debt.^3 Whether this is

high or low or whether it even makes any difference depends on whether or not capital

structure matters, a subject we discuss in Part 6.

Prufrock has $.28 in debt for every $1 in assets. Therefore, there is $.72 in equity

($1
 .28) for every $.28 in debt. With this in mind, we can define two useful variations

on the total debt ratio, the debt-equity ratio and the equity multiplier:

Debt-equity ratio Total debt/Total equity

$.28/$.72.39 times

[3.7]

Equity multiplier Total assets/Total equity

$1/$.721.39 times

[3.8]

The fact that the equity multiplier is 1 plus the debt-equity ratio is not a coincidence:

Equity multiplier Total assets/Total equity $1/$.721.39

(Total equity Total debt)/Total equity

 1 Debt-equity ratio 1.39 times

The thing to notice here is that given any one of these three ratios, you can immediately

calculate the other two, so they all say exactly the same thing.

A Brief Digression: Total Capitalization versus Total Assets Frequently, financial

analysts are more concerned with the firm’s long-term debt than its short-term debt, be-

cause the short-term debt will constantly be changing. Also, a firm’s accounts payable

may be more of a reflection of trade practice than debt management policy. For these

reasons, the long-term debt ratio is often calculated as:

Long-term debt ratio 

.15 times

[3.9]

The $3,048 in total long-term debt and equity is sometimes called the firm’s total capi-

talization, and the financial manager will frequently focus on this quantity rather than

on total assets.

To complicate matters, different people (and different books) mean different things

by the term debt ratio. Some mean a ratio of total debt, and some mean a ratio of long-

term debt only, and, unfortunately, a substantial number are simply vague about which

one they mean.

This is a source of confusion, so we choose to give two separate names to the two

measures. The same problem comes up in discussing the debt-equity ratio. Financial an-

alysts frequently calculate this ratio using only long-term debt.

$457

$3,048

$457

$457 2,591

Long-term debt

Long-term debt Total equity

$3,588
2,591

$3,588

Total assets 
Total equity

Total assets

66 PART TWO Financial Statements and Long-Term Financial Planning

(^3) Total equity here includes preferred stock (discussed in Chapter 8 and elsewhere), if there is any. An
equivalent numerator in this ratio would be Current liabilities Long-term debt.
The on-line Women’s
Business Center has
more information on
financial statements,
ratios, and small
business topics
(www.onlinewbc.org).
Ratios used to analyze
technology firms
can be found at
http://www.chalfin.comunder
the “Publications” link.