in an environment where the foreign currency is depreciating why would debt to equity and debt to capital be lower using the temporal method than the current method?
You should put together a simple balance sheet and work out the ratios for yourself; you’ll understand it a lot better (and remember it a lot easier) than if someone here does all of the work for you.
The way I solve these problems, and get them right each time:
1.) Make up some exchange rates (usually 1 at beg of year and 1 at end of year) based what the problem states… For example, FC is appreciating relative to DC
2.) Make up some ratios that the problem asks such as Receivers Turnover (sales/recv)
3.) Do temporal, do Current rate, do local on the ratio you made up
4.) Now answer the question, which one is higher, which one is lower or will it stay the same.
Thanks guys but my question is not how to do it, my question is why it is lower?
And the answer is that if you do it yourself you’ll see why it’s lower.
Debt/Equity Debt is translated using the current fx rate in both methods. Equity will be determined by the current fx rate in the current rate method, but some components of it (like inventory etc) will be based on historical rates under the temporal method. Since historically the foreign currency is stronger, when you translate it, you get more equity in the presentation current using the temporal method.
The same debt is divided by a higher Equity denominator in the temporal method, hence giving a lower D/E ratio.
Tactics gives the good detailed response, but also, think about this. Under the Temporal Method, there is usually a Net Liability Balance Sheet position. Would you want the Foreign currency to be strengthening if that were the case? No you wouldn’t. Therefore, having it weaken is beneficial for the parent company, hence lower D/E and D/TC