Leverage ratios in Intercorporate investments

Why does your leverage ratios go down under equity method. If you have higher equity in the acquisition method, wouldn’t your debt/equity ratio be lower?

are you comparing the equity method to the acquisition method or are you using the equity and acquisition method interchangeably in your question?

Equity method is essentially a one-line consolidation (you report your investment in the associate as a non-current asset) and equity will go up - nothing else happens on the L + E side. So leverage is lower (only parent’s debt is reported but equity increases) under equity than under acquisition.

Under acquisition method, you’re reporting ALL assets and ALL liabilities with a minority interest in equity for the portion of the company you don’t own. The target’s equity is eliminated, and the only other change here is that equity may be increased by any stock that was issued to fund the investment.

Maybe you’ll get lucky and S2000 will chime in and make it clearer than this…

When you compare the equity method to full or partial consolidation, two values remain the same:

  1. Net income is the same under equity method and consolidation
  2. Shareholders’ equity is the same under the equity method and consolidation. (Assuming you don’t include minority interest in shareholders’ equity.)

Assets are higher under consolidation, and liabilities are higher under consolidation.

Thus, leverage is lower under the equity method (lower liabilities, same equity) and higher under consolidation (higher liabilities, same equity).

Trick in an exam, they might ask whether Net Proft Margin (and not net profit itself) will be better between all the methods. NPM will always be better under equity because Sales are less than in consolidation method.

S2000, schweser seems to think that ROE is the same under proportionate consolidation and equity method however CFAI doesn’t. what is the deal? proportionate consolidation doesnt have minority interests?

I haven’t a copy of the CFA Institute books, so I cannot say what they have in them. I’d encourage you to look carefully at how each defines “shareholders’ equity” for ROE and D/E and so on.

Bringing this thread back to life:

I notice that S2000 suggests that we ingore minority interest in the equity. Therefore Equity remains the same for both Acquisition method and Equity method?

If this is the case I am wondering why do the schweser notes suggest that Equity is lower under equity method and therefore ROE is higher?

Also, I am wondering why they suggest that with Leverage, equity method has lower number compared to Acquisition as it says that equity remains the same under both with liabilities higher under acquisition.

To summarise:

  1. Is equity the same under both or is consolidation showing higher equity.

  2. Why does ROE change between the two due to lower equity in equity method compared to leverage where equity remains the same.


rex, the best way to approach this is through a simplified example. It can illustrate the concepts very well. but to get to the end, D/E will almost always be lower under the Equity Method.

Parent before acquisition:

  • Assets = 10. Liabilities = (8). Equity = 2. Therefore D/E = 8/2 or 4

What happens when we throw in a simple 50% acquisition of a company Assets=6. Liabilities = (4). Equity = 2 Do your ratios under consolidation and Equity method and see what happens:

  • Equity Method: Assets = 10+1. Liabilities = (8). Equity = 2+1. Therefore D/E = 8/3 or 2.67.
  • Consolidation: Assets = 10+6. Liabilities = (8)+(4). Equity = 2+2. Therefore D/E 12/4 or 3.0

You can use this simplified example to see how various ratios play out and to help it make intuitive sense.

I think debt has to be lower than purchase price. Then,

D/E > (D+debt)/(E+purchase price)


But if you have different scenario:

when we throw in a simple 50% acquisition of a company Assets=3. Liabilities = 1. Equity = 2

Parent before acquisition:

  • Assets = 10. Liabilities = (8). Equity = 2. Therefore D/E = 8/2 or 4

Do your ratios under consolidation and Equity method and see what happens:

  • Equity Method: Assets = 10+1. Liabilities = (8). Equity = 2+1. Therefore D/E = 8/3 or 2.67.
  • Consolidation: Assets = 10+3. Liabilities = (8)+(1). Equity = 2+2. Therefore D/E 9/4 or 2.25

In this scenario, D/E under equity method is higher than under acquisition method.

I found this question in Schweser

When comparing companies that hold equity investments in other corporations, which of the following statements is most accurate? All else being equal, leverage measures for a firm using consolidation will appear:

  • A/less favorable than those for a comparable firm using the equity method.
  • B/more favorable than those for a comparable firm using the equity method.
  • _ C/more or less favorable depending on the leverage of the investeee company. _

The right answer is C.

Explanation: Under consolidation, the debt of the subsidiary is included in the parent company balance sheet. Parent company’s equity is also increased due to minority interest. The impact on leverage will depend on the leverage employed by the subsidiary.

Its confusing.

I think D/E under consolidation doesn’t include minority interest. So add purchase price.

If its “how much total equity would increase after consolidation?” sort of question, then calculate total number of shares outstanding x stock price and add.

Please correct me if I’m wrong.

D/E under consolidation would have to include minority interest. If it didn’t, there would be a mismatch. You’d be including all liabilities, but not all equity.

As to the next comment, the equity in debt/equity is an accounting question, not a market value question. Assets are financed by some combination of debt and equity. D/E is looking at tis financing mix.

Do you have curriculum book? EOC 26 is “D/E most likely lower if under which method” question. Answer as follows:

26. A is correct. Using the equity method, long-term debt to equity = £600/£1,430 = 0.42 (this is without adding subsidiary no change). Using the consolidation method, long-term debt to equity = long-term debt/equity = £1,000/£ 1,750 = 0.57. Equity includes the £320 noncontrolling interest under either consolidation(->??? is it an error?). It does not matter if the full or partial goodwill method is used since there is no goodwill.

->1,750 is book value equity (850+580=1,430) plus how much NinMount paid(320) to purchase a 50% stake. 1,000 is long term debt 600+400.

Compare it with CFAI text 6.4.3. Non-controlling (Minority) Interests: Income Statement section. ROA and ROE include minority interest but EOC 26 doesn’t. It might be an error, I don’t get it.

I may add later but there is one more from Surburban.

Please someone clarify why 320 is added? What is this?

I remember this question from when I was an L2 student last year.; it is a relatively challenges one and requires that you know how to consolidate the companies to figure out what the consolidated equity is. That part may be outside of the scope of the curriculum, I’m not sure. I gave an answer to a similar question here:


I just noticed “Investment in Boswell” is already recorded. Then earnestly, is 320 minority interest? Mega confusing because its 50:50.

Right. The minority interest is $320. The Equity section of the Consolidated BS would show $1,430 and then a separate line for the $320 minority interest (totaling $1,750)

This is a pretty hard question, at least the part to arrive at consolidated equity. Unless someone had a pretty good idea of how consolidations work I doubt they could get to the right answer. I don’t think any exam question on the actual exam required anything like this.

Then can I say,


Only under full goodwill method?

Leverage can improve if DS/FMVS is lower than DA/EA ?

The inequality DA/EA > (DA+DS)/(EA+FMVS) is true if and only if DA/EA >DS/FMV S

and not only under full goodwill method.

Leverage decreases if DS/FMVS is lower than DA/EA

Mega thanks, 40yo