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The document discusses the impact of debt-to-equity ratio on a firm. It defines debt and equity, and explains that debt-to-equity ratio indicates the level of financial risk for a company based on its use of debt versus equity. It provides an example calculation and states that ratios below 1 are generally considered good by lenders, while ratios above 2 are seen as risky. The ratio should be analyzed in the context of a company's industry. Both benefits and drawbacks of a high ratio are outlined.

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101 views

Assignment

The document discusses the impact of debt-to-equity ratio on a firm. It defines debt and equity, and explains that debt-to-equity ratio indicates the level of financial risk for a company based on its use of debt versus equity. It provides an example calculation and states that ratios below 1 are generally considered good by lenders, while ratios above 2 are seen as risky. The ratio should be analyzed in the context of a company's industry. Both benefits and drawbacks of a high ratio are outlined.

Uploaded by

pankajjaiswal60
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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ASSIGNMENT

Name: Pankaj Kumar


Student ID: 21261147
Course: MBA (Marketing)
Subject: Corporate Finance
Date: 10/08/2020

Q. What is the impact of debt equity ratio on value of firm or a company?


ANS: Before talking about debt equity ratio or how it impact on any firm or company we need
to know first about debt and equity.
(a) Debt: Debt is all the liabilities that a business owes to another entity, such as a business,
organization, employee, government agency, or vendor. It typically incur debt as part of normal
business transactions.
(b) Equity: Equity is the ownership or value of a company. Equity can be the amount of funds
(aka capital) that is invested in a business.
Sometimes, debt is a necessary evil when running a business. Taking on debt may be best
option when we don’t have enough equity to operate. But, how much debt is too much debt?
And, when does debt become “bad”? To accounting this we have to take the help of debt
equity ratio .To determine how much is too much and draws the line between good and bad
debt ratios.
So, in very simple words we can say debt-to-equity ratio basically gives the idea of financial risk.
On the other hand we can also say that the debt-to-equity ratio meaning is the relationship
between debt and equity to calculate the financial risks of any business or firm.
Mathematically,

Debt-to-equity Ratio = Total Debt / Total Equity


For better understanding let’s take one example
Q. There is firm who need to do some investment to grow his business .Now the firm has two
option either they invest total equity or they take some debt and invest together with equity.
Suppose firm take debt of $5,000 and firm have equity $10,000.Calculate debt-to -equity ratio?
Ans: By using above formulae we find debt-to-equity ratio
Debt-to-equity Ratio = Total Debt / Total Equity
= $5,000 / $10,000
= $0.5
Debt-to-equity ratio tells us how much debt we have per $1.00 of equity. Debt-to-equity ratio
is 0.5, a ratio of 0.5 means that we have $0.50 of debt for every $1.00 in equity.

Debt-to-equity ratio may be good or negative the debt-to-capital ratio can help to determine if
we have too much business debt. But, how do anyone decide how much is too much? Well,
that depends on business and the services or goods that offered.

What is a good debt-to-equity ratio? Generally, lenders see ratios below 1.0 as good and ratios
above 2.0 as bad. However, the ratio does not take into account in business’s industry, so we
do have some wiggle room between good and bad. A good debt-to-equity ratio in one industry
(e.g., construction) may be a bad ratio in another (e.g., retailers) and vice versa.
Sometimes, a business has a ratio that is negative rather than positive. A negative debt-to-
equity ratio means that the business has negative shareholders’ equity. If liabilities are more
than assets, then equity is negative.

Typically, lenders, stakeholders, and investors consider a negative debt-to-equity ratio to be


risky. When the ratio is negative, it might indicate business is at risk of bankruptcy.
The debt-to-equity ratio tells a company the amount of risk associated with the way its capital
structure is set up and run. It means debt equity ratio shows the financial risk. The ratio
highlights the amount of debt a company is using to run their business and the financial
leverage that is available to a company. Company owners want to know if their debt is rising,
decreasing, or staying steady. The answer indicates whether or not their company is being
overwhelmed by financial obligations or has room to grow.
In order for companies to profit in competitive markets, they need to understand their financial
capabilities. Useful accounting tools, such as the debt-to-equity ratio, inform business managers
how and when they can take risks and grow their company. The debt-to-equity ratio can help
business managers understand the status of their debt to equity so that they can make
knowledgeable decisions about important financial strategies for their company.

Companies can benefit from being aware of how their day-to-day decisions affect their debt-to-
equity ratio. This knowledge, in turn, can affect other financial aspects of the company. The
management of cash flow accounts receivable and payable, and inventory can influence the
final debt-to-ratio number. This final number can have an impact on how the company’s capital
structure is perceived by investors and shareholders

When to use the debt-to-equity ratio?


For the following we have to use debt -to- equity ratio.

Financial analysis
When it’s time for potential lenders or stakeholders to make a decision about company, they
look at debt-to-equity ratio. Specifically, investors look at the ability to pay off debt and how
much of your company depends on debt.

Stakeholders look at all the financial data as well as industry. If you are in an industry that
performs work and invoices after you complete a project, that information is important. Why?
You may be less of a risk because your customers owe you and you’re expecting a payment.

But if you are in an industry that accepts payment upfront, your ratio may indicate a higher risk.

Risk analysis
Investors and stakeholders are not the only ones who look at the risk of a business. Lenders
usually use the debt-to-equity ratio to calculate if your business is capable of paying back loans.
The credit trustworthiness of your business lets lenders know if you can afford to repay loans.

Lenders also check your past records and installment payments to ensure you actively repay
your debts.

Determining shareholder earnings


If you have shareholders, you pay them part of your profits. And when it comes time to pay out
the shareholder dividends, you base the shareholder earnings on the business’s profits. But if
your debt-to-equity is too high, your profits can decrease. For shareholders, this might mean
that you reduce their earnings because you must use your profits to pay any interest or
payments on debt.

Limitations of the Debt-to-Equity (D/E) Ratio


When using the D/E ratio, it is very important to consider the industry in which the company
operates. Because different industries have different capital needs and growth rates, a
relatively high D/E ratio may be common in one industry, while a relatively low D/E may be
common in another.

Utility stocks often have a very high D/E ratio compared to market averages. A utility grows
slowly but is usually able to maintain a steady income stream, which allows these companies to
borrow very cheaply. High-leverage ratios in slow-growth industries with stable income
represent an efficient use of capital. The consumer staples or consumer non-cyclical sector
tends to also have a high D/E ratio because these companies can borrow cheaply and have a
relatively stable income.
Analysts are not always consistent about what is defined as debt. For example, preferred stock
is sometimes considered equity, but the preferred dividend, par value, and liquidation rights
make this kind of equity look a lot more like debt.

Including preferred stock in total debt will increase the D/E ratio and make a company look
riskier. Including preferred stock in the equity portion of the D/E ratio will increase the
denominator and lower the ratio. It can be a big issue for companies such as real estate
investment trusts (REITs) when preferred stock is included in the D/E ratio.

Benefits of a High D/E Ratio


A high debt-equity ratio can be good because it shows that a firm can easily service its debt
obligations (through cash flow) and is using the leverage to increase equity returns.

In the example below, we see how using more debt (increasing the debt-equity ratio) increases
the company’s return on equity (ROE). By using debt instead of equity, the equity account is
smaller and therefore, return on equity is higher.
Another benefit is that typically the cost of debt is lower than the cost of equity, and therefore
increasing the D/E ratio (up to a certain point) can lower a firm’s weighted average cost of
capital (WACC).

Drawbacks of a High D/E Ratio


If a company has a D/E ratio that’s too high. In this case, any losses will be compounded down
and the company may not be able to service its debt.

If the debt to equity ratio gets too high, the cost of borrowing will skyrocket, as will the cost of
equity, and the company’s WACC will get extremely high, driving down its share price.

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