At December 31, 2016, Fred Williams Company has total assets of $1,000,000, total liabilities of $720,000, and total owner’s equity of $280,000. At December 31, 2016, Fred Williams Company’s debt-to-equity ratio is:
options: A) 0.72 B) 0.28 C) 2.57 D) 5.00
The correct answer and explanation is:
Correct Answer: C) 2.57
To calculate the debt-to-equity ratio, the formula used is: Debt-to-Equity Ratio=Total LiabilitiesTotal Owner’s Equity\text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Total Owner’s Equity}}
Given:
- Total Liabilities = $720,000
- Total Owner’s Equity = $280,000
Now apply the values: 720,000280,000=2.5714≈2.57\frac{720,000}{280,000} = 2.5714 \approx 2.57
So, the correct debt-to-equity ratio is 2.57.
Explanation:
The debt-to-equity ratio is a key financial metric used to evaluate a company’s financial leverage. It shows how much debt the company is using to finance its assets relative to the value of shareholders’ equity. This ratio gives insight into the financial stability and risk level of a company.
A ratio of 2.57 means that for every dollar of equity, Fred Williams Company has $2.57 in liabilities. This suggests the company is significantly reliant on borrowed funds compared to its own equity financing. Generally, a higher ratio indicates higher financial risk because it implies the company must meet more obligations to creditors.
Companies with high debt-to-equity ratios may face difficulties in securing new financing, especially if creditors perceive the business as over-leveraged. On the other hand, some companies strategically use debt to boost returns, especially in industries where growth requires large capital investments.
In contrast, a lower debt-to-equity ratio shows that a company relies more on shareholder equity than debt. This may be viewed as more conservative and financially stable, but it could also mean the company is not taking advantage of potential growth through leverage.
In conclusion, Fred Williams Company has a debt-to-equity ratio of 2.57, indicating it uses significantly more debt than equity to fund its operations. This is an important figure for investors, creditors, and analysts when assessing the financial health and risk level of the business.