My understanding is that the capitalization of an expenditure would not change debt-to-assets. Any gain in assets would be offset by a deduction in cash or a raise in debt so the ratio would not change. That seems straitforward. I bring it up because for one of the problems I was working on, in the solution it said…
“the asset created by capitalizing the cost would increase assets, so the debt-to-assets ratio would decrease”
According to my orignal understanding, that statement makes no sense. (how can assets increase if cash is simultaneously being deducted?) Where am I going wrong in my original understanding?
The debt-to-assets ratio when you capitalize an expenditure is greater less than the debt-to-assets ratio when you expense that same expenditure.
Perfect… It was just a matter of comparison and I have no misunderstandings. … you did mean debt - to - assets is less than… not greater than when capitalized rather than expensed, right?
I did, indeed; good catch.
I fixed it.
KMeriwetherD
Capitalization will always carry to better solvency and profitability ratios vs currently expensing purchasing in first years. In latter years, due to impact of depreciation, those ratios will be lower (assuming all else equal).
In your first post, your point would be good if you are faced with choices:
- Spend the cash, buy asset, capitalize an asset vs - Do not spend cash, do not purchase, do not capitalize asset in choice above solvency ratios would be currently almost same due to capitalization, but liquidity ratios would be worse since LT asset is less liquid than cash. If you assume the purchase of asset in the choice to capitalize or immediately shown as an expense then applies the rule mentioned in the first paragraph.