Question

250 words

What is the impact of a stock repurchase on a company’s debt ratio? Does this suggest another use for excess cash?

Answer 1

Stock repuchase or buy back of shares means the act of purchasing its own stock by a company from the open market. A company adopts the scheme of stock repurchase i) When the company wants to increase promotor's holdings or ii) when the stock is trading in the market at a price lower than the book value or iii) when the company has surplus cash. After stock repurchase, equity of the company decreases but the debt amount remains unchanged and hence as a result debt ratio of the company rises. For example, if ABC Company has equity worth $10,000 and debt worth $5,000. Now, company repurchases its stock worth $2,000 from the market. After stock repurchase, value of equity reduces to $8,000.

Debt ratio (before repurchase) = Debt/Assets

= 5,000/15,000

= 0.33

Debt ratio (after repurchase) = Debt/Assets

= 5,000/13,000

= 0.38

The above example clarifies that after stock repurchase, debt ratio rises.

Surplus cash with the company can be utilized in the following manners:

i) For payment of dividends

ii) For redemption of debt

iii) For purchase of fixed assets