A company has a Debt-to-Equity ratio of 1.5. It purchases a machine by signing a 5-year note payable. How does this transaction affect the Debt-to-Equity ratio and the Return on Assets (ROA) immediately?

Answer options:

Increase Debt-to-Equity; Decrease ROA

Increase Debt-to-Equity; Increase ROA

Decrease Debt-to-Equity; Decrease ROA

No change to Debt-to-Equity; Decrease ROA

How to approach this question

Analyze the components. D/E = Total Liab / Total Equity. ROA = Net Income / Avg Total Assets. <br/>Transaction: Debit Asset, Credit Liability.

Full Answer

A.Increase Debt-to-Equity; Decrease ROA✓ Correct

1. Debt-to-Equity: Liabilities increase (Note Payable). Equity is unchanged. Ratio increases.<br/>2. Return on Assets: Total Assets increase (Machine). Net Income is unchanged immediately. Since the denominator (Assets) increases, the ratio decreases.

Common mistakes

Confusing the direction of the ratio change when the denominator increases.

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