Question

Describe the debt to equity ratio and explain how creditors/owners can use this ratio to evaluate risk.

Is it more advantageous to issue bonds or obtain financing? Defend your position.

Answer 1

Debt – Equity ratio is a measure of relative contribution of the creditors and shareholders in the total capital employed in the business. In simple it is ratio of long term debt and shareholder equity in the business.

It is one of the important solvency ratio tracked in industry. It indicates how much borrowed capital can be fulfilled in event of liquidation of the firm using shareholder contribution. This ratio also indicates the financial leverage and soundness of the firm. A financial leverage indicates how much benefit can be given to shareholders after a fixed charge on debt taken for capital employed.

A low debt-equity ratio is favorable from investment point of view as it is less risk due to lower interest and debt obligations outflow and also degree of financial leverage is lower. It also attracts additional capital for further investment from investors. Creditors usually do not lend to firms having high debt equity ratio.

If Debt equity ratio is lower that means there is scope for financial leverage and hence it may be advantages to issue bonds.

But if Debt equity ratio is already higher it is better to obtain equity financing and manage the risk better.

Below table shows the risk return using debt and equity

	If Debt is high	If Debt is low
Risk	Risk is higher due to Interest and principal obligations	No Risk
Return	Higher the profit higher returns to shareholders	Firm can take debt and obtain financial leverage advantage
Additional Financing	Obtain Equity Financing to manage Debt Equity ratio	Take Debt within the Debit Equity ratio