8.2.2 To Buy or Not to Buy?

Video clip iconA 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.

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Activity symbolActivity: 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.

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Comment

Have you identified the total amount of debt before the purchase? How about after purchasing the hot tub?

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Answer

Before:

Your total debt (liability) is dollar 12 comma 000 postfix plus dollar 11 comma 200 equals dollar 23 comma 200. Your equity (asset) is $35,300.

The debt-to-equity ratio without the purchase is dollar times 23 comma 200 divided by dollar times 35 comma 300 almost equals 0.66.

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 dollar 12 comma 000 postfix plus dollar 11 comma 200 postfix plus dollar 15 comma 000 equals dollar 38 comma 200. The equity would remain $35,300. So, the debt-to-equity ratio after purchasing the hot tub would be dollar times 38 comma 200 divided by dollar times 35 comma 300 almost equals 1.08.

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!

8.2.1 Salad Dressing Recipe

8.2.3 Ratios in Recipes