A firm’s balance sheets for the last two years are as follows:
Year 2019
Assets Liabilities and Equity
Cash $ 9,000 Accounts payable $12,000
Market securities 10,000 Accruals 10,000
Accounts receivable 21,000 Current bank note 10,000
Inventory 20,000 Long-term debt 30,000
Plant 40,000 Common stock 14,000
Retained earnings 24,000
$100,000 $100,000
Year 2020
Assets Liabilities and Equity
Cash $12,000 Accounts payable $12,000
Market securities 18,000 Accruals 10,000
Accounts receivable 18,000 Current bank note 30,000
Inventory 10,000 Long-term debt 10,000
Plant 42,000 Common stock 18,000
Retained earnings 20,000
$100,000 $100,000
Sales in 2019 were $500,000. Sales in 2020 were $500,000.
Has the firm’s risk exposure increased?
To measure firm's risk exposure , we will calculate Debt equity ratio(D/E Ratio). Higher the debt equity ratio, higher the firm has risk exposure.
D/E ratio = Debt / Equity
In year 2019
Long term debt - 30,000
Equity = Common Stock + Retained earnings = 14000+24000 = 38000
D/E Ratio = 30000/38000
D/E Ratio = 0.79
In year 2020
Long term debt - 10,000
Equity = Common Stock + Retained earnings = 18000+20000 = 38000
D/E Ratio = 10000/38000
D/E Ratio = 0.26
The firm's D/E ratio has substantially reduced from 0.79 to 0.26 in year 2020. Therfore the firm has reduced its risk exposure.
Answer is no. The firm's risk exposure has not increased. It has been reduced in Year 2020
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