Leverage ratios in Intercorporate investments

[itys.cfa]

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?

 

[cgottuso8190]

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….

 

[S2000magician]

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).

 

[DeadCatBounce]

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?

 

[S2000magician]

trogulj wrote: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.