Question

Many of the ratios that we look at involve comparing debt or liabilities to either assets or equity. Debt is sometimes thought of as a bad thing to avoid at all cost, and some companies even go so far as to have zero debt. Is this always a good idea? What are some benefits that reasonable amounts of debt can provide?

Answer 1

For making good financial analysis we have to make ratios between debt and assets or between debt and equity etc. We all know that debt may be good for the firms or may be bad for the firms as well. But if we say that zero debts is always good idea then this statement is incorrect because debt have potential to generate leverage effects for the firm hence zero debts is not good idea always. We know that debts always carry fixed interest burden hence in case of higher earnings use of debts will help in maximizing EPS or maximizing wealth of the firms as well. In other words we can say that use of debts can generate positive results too, Thus use of debts always is not negative for the firms.

Resonable amount of debts can provide a lot of benefits for the firm but amount of debt must be reasonable because excess or short amount of debts is not good for the firm that is why a firm should use reasonable amount of debts in its’ capital structure to generate positive results for the firm. Followings are the common benefits of using reasonable amount of debts;

1. It helps in minimizing overall cost of using capital because debts always carry fixed amount of interest.

2. It helps in maximizing EPS for the firm because in case of higher net income EPS will be higher.

3. Interest expense on debts is tax deductible that is why it will help in minimizing tax liabilities for the firm.

4. It will help in raising adequate amount of funds for the firm in real time time.

5. It will help in minimizing excessive control of shareholders on the management, thus as a result management will take decisions more smoothly etc.