8.2.2 To Buy or Not to Buy?
A very important ratio is the debt to equity (or liability to asset) ratio. For example, it is used as a guide to determine how much money a business or individual should be lent by banks. Check out this short video, which provides more details.
Activity: To Buy or Not to Buy?
You really would like to purchase an eight-person hot tub. Before you apply for a $15,000 loan, you should determine what your debt-to-equity ratio would be before and after making such a purchase.
The combined amount in your checking and savings account is $35,300. Currently, you have credit card debt of $12,000 and still owe $11,200 on your school loans.
Calculate your debt-to-equity ratio before and after the purchase.
Have you identified the total amount of debt before the purchase? How about after purchasing the hot tub?
Your total debt (liability) is . Your equity (asset) is $35,300.
The debt-to-equity ratio without the purchase is .
After: [ Credit card debt is usually at a very high interest rate. You should seriously consider paying that off before making another large purchase! ]
The total debt would be . The equity would remain $35,300. So, the debt-to-equity ratio after purchasing the hot tub would be .
Prior to the purchase, your debt to equity ratio is less than 1, which means you have more than you owe.
However, if you decide to take out a loan to buy the hot tub, your debt to equity ratio becomes larger than 1, which means you owe more than you have.
In other words, it’s probably not a wise decision to take out a loan to purchase this commodity!