If you are the newly hired Finance leader of a company with a debt ratio of...

If you are the newly hired Finance leader of a company with a debt ratio of 1.1 and one of your initial tasks is to reduce this ratio under 1 would it be more advantageous to reduce the numerator (debt liability) or increase the denominator (total assets). Are either of these levers more important than the other when reducing this ratio?

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Expert Solution

The reduction in debt usually involves payment of debt. Hence, this reduction would also reduce the asset at same value. When the debt ratio is 1.1 and both debt and total assets are reduced by same value, then the debt ratio does not go below 1. Instead it would be higher than 1.1. Hence, reduction of debt is not more advantageous to the company.

The increase in total assets would also increase the value of debt with the same value if such increase in asset is financed by debt. However, such increase in total asset would not further deteriorate the debt ratio. The debt ratio would be lower than 1.1 but it would not get below 1. So, the increase in asset would be more advantageous to improve the debt ratio than reduction of debt.

However, in both the case, the debt ratio may not be reduced below 1. If the company wishes to reduce the debt ratio below 1, than it may opt any of the below strategies-

Increase in asset by obtaining finance from equity.
Conversion of debt into equity.

ekkarill92 answered 1 year ago

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