Do Financial Leverage (Avg total assets/Avg total equity) and Debt/Assets always move in the same direction when repurchaisng stock using debt? Do they both always increase, I guess assuming the earnings are higher than the after tax cost of debt?
When you repurchase stock think of the transaction itself. A decrease in cash (asset) and a decrease in share capital (equity). That mean debt / asset will increase.
For asset / equity. Assuming that this ratio is greater than 1 meaning the numerator is greater than the denominator, an equal deduction in both asset and equity will decrease the denominator more than it decreases the numerator (think of percentage decrease). Therefore, the ratio asset / equity will increase as well.
Asset = Liabilities + Equity, so the ratio is always greater than 1 or equal to 1 if there’s no liability. The same amount of decrease will decrease the denominator more than it does to the numerator. If you feel confused when encountering such the questions, write down a hypothesized ratio to verify your reasoning.
What about for debt to asset ratio do I make it equal to greater than 1
Again, you look at the equation Asset = L + E to figure it out. If you add equal amounts to A and L, the ratio will typically increase. It is because typically assets are larger than debt (liabilities) so the numerator increases by a greater proportion than the deniminator when equal amout are added to each. Write down an example to verify: debt to asset = 7/10= 0.700, add 1 to each , we have 8/11 = 0.727.
I always do it this way to confirm my reasoning. :). I find it really helpful when coping with current ratio, quick ratio question.
Indeed this helps me understand alot more now. Thanks
Think it in this way, we have issued debt to buy back equity shares it means we have more debt but less equity prospectively.
So effects,
Avg total assets/ Avg total equity = it will increase( Equity decrease).
Debt/ Asset = It will increase also(Debt increase).