Question

Compare the relative proportions of debt and equity in a company’s capital structure. Are they similar? If not, can you explain why they are not similar?

Answer 1

Debt and equity are both used to acquire funds for the operation of a firm. Debt providers are the creditors of the firm and the equity providers are the shareholders who are the owners of the firm. The amount of debt and equity as a proportion of total asset value is used to evaluate the riskiness of the firm. High debt to equity signals high risk as firm is getting more of its funds by borrowing money, and the more the firms dependency is on borrowed money for its operations, the more is the risk of bankruptcy, if the firms business goes downhill. Thus for a highly leveraged company, decline in its sustained earnings could lead to financial distress or even to bankruptcy in extreme cases.

Interest expense for debt is tax exempted. Also funds acquired from debt can also be used appropriately for the growth of business. Thus some debt in the firms balance sheet is good for the firm. Thus very low debt to equity decreased risk ( as less leverage) but is not ideal as this leads to under utilization of available resources. Thus the ideal debt to equity ratio of a firm should be decided based on the industry norms, tax regimens and the general market accepted values.