# Capitalizing - leverage ratio

Can some one please explain the effects of capitalizing as opposed to expensing. How does this affect the leverage ratio? Leverage = assets/equity When capitalizing does your asset increase by the same amount as your equity? (also when expensing, you reduce your net income… so does this reduce your equity by the same amount?)

also could someone explain this in regards to assets = liabilities + equity

take a very simplified example of a company thats starts with \$100 cash financed 50/50 with debt and equity the beginning balance sheet is assets - 100 (cash) liabilities debt - 50 equity - 50 assume the company generates revenue of \$1000 during year 1, cost of sales \$500, purchases new equipment for \$100 (10 year useful life), no taxes, no interest expenses case 1 - expense new eqpt the income statement is profit = 1000-500 - 100 = 400 which flows to equity. assuming all transactions are cash based, cash will increase by the same amount the balance sheet becomes assets - 500 (100 begng cash + 400 cash generated during year) liabilities debt 50 equity 450 (50 beginning equity + 400 retained earnings for the year) leverage ratio = 500/450 = 1.11 case 2 - capitalize new eqpt (=> only charge \$10 depreciation for the year) the income statement is profit = 1000-500 - 10 = 490 which flows to equity. the increase in cash is still 400 as before since accounting treatment (capitalizing vs expensing) does not impact cash flow (technically different taxes will impact cash, but we ignore taxes for this example) the balance sheet becomes assets - cash 500 (100 begng cash + 400 cash generated during year) equipment 90 (100 less 10 of accumulated depreciation) total assets 590 liabilities debt 50 equity 540 (50 beginning equity + 490 retained earnings for the year) total liab + equity = 590 leverage ratio = 590/540 = 1.09 generally, both assets and equity are higher under capitalization. but equity increases by a larger % compared to the increase in assets hence the leverage ratio is lower.

perfect thanks v much for that

When yuo capitalize, you inicrease your assets and your NI, which increase Equity. with the accoutnign equation, A = L + E, so we know A>E. That means that when you capitalize an asset, the equity will change by a higher percent than assets. In the leverage ratio A/E, E changes by a higher percentage than A so the denominator has a bigger percent change, meaning it has a bigger weight on the ratio. This will decrease the ratio.

thanks, does improving the leverage ratio mean that the ratio goes lower?

Usually lower debt ratios (like d/e or d/a) are preferable. Im not fully sure if a lower leverage ratio is improving, although it would seem like it would be better if its the same rationale as the debt ratios. Then again, a lower leverage ratio leads to lower ROE and lower growth rate, which leads to lower stock price in DDM. I guess it may depend on what you mean by “better”? anyone have any thoughts?

Spanishesk Wrote: ------------------------------------------------------- >I guess it may depend on what you mean by “better”? anyone have > any thoughts? The devil is in the details on these matters. what you are really wanting to understand is the quality of the assets that are being capitalized on the balance sheet – such that they justifiably represent value on behalf of claimants (equity/debt holders), rather than the absolute ratio figure in an abstract moment of time. If i’m Microsoft and I say I have a 20 year track record selling Microsoft Office, so I’m going to capitalize most of my development costs for the next version of MS Office 2015, my auditor will probably say fine. You can then make your own judgement about the risks (Google Docs, competition, etc.) and quality of that asset. There is a bit of gamesmanship that goes on in this area and it can sometimes be confusing because companies in virtually the same business can have different financials (companies which capitalize vs. those which do not).

In this case the D/E ratio is a better measure of a company’s leverage than the leverage ratio itself. Technically, when you capitalize the leverage ratio doesn’t really improve because you’ll have to depreciate or amortize the asset in the later years. Recognition of something like an ARO, on the other hand, leads to a permanent increase in both the D/E and the leverage ratios because you have a growing liability.

cokecan Wrote: ------------------------------------------------------- > thanks, > > does improving the leverage ratio mean that the > ratio goes lower? YES !!

could you explain this:
comparing with the company that capitalizes cost,the company that expenses immediately will LEASET likely:
A earn lower ROA
b have lower financial leverage
C lower CFO
the answer is B but since you guys explained capitalizing decrease financial leverage, then, expense will leads to higher financial leverage. However, the book said expensing leads to lower financial leverage since it has lower equity.

Lower equity would give higher leverage.

Are you sure that the book (which book, by the way?) says otherwise?

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