Debt to Equity : Solvency is important…

FORMULA 

(Total Liabilities / Shareholders Equity)

Every Company need Capital for its operations. There are ways to raise funds. Two of them are Equity and Debt. Both of them have pro’s and con’s. As Capital is Base for growth and life of the company and also it decide the solvency for long-term, its important to study the profile of Debt and Equity while Investing in the company.

 

 

Debt is come up with fixed Cost and there is maturity for Debt which is not the case in Equity. Out of two types of debt, if company choose Bank loan, it is one of the worst situation for company. That is the payment is high and nearly similar throughout the tenure. But with Debentures or bond, the company only need to pay interest. Many times that is also semiannual or Annual.

 

When the company raises Debt, then its important for the company to service the debt. For that the company need to keep Cash in its hand or make atleast that amount. Higher the debt higher the amount of interest which increases Risk for company. With Equity Capital it is no burden on company that to pay dividends. 

There are some pro’s for Both. Like The interest paid on dent is Tax deductible which makes the Debt as lowest cost Capital. Right mix of Debt in Capital will make return for Equity shareholders as Anything above the cost of Debt is in hand of Equity shareholders.

Growth implies significant Equity financing and as growth is the essential feature of the Real world. Any Investor is investing because of growth potential. Even value investors also seeking growth in portfolio value so Equity is important. Even in Bank where there is no revenue but there are funds which are mostly borrowed. Equity playing key role for growth.

When there is high Debt visible on balance sheet, two things are possible. Either the company is sure about its growth and they have Funds to service it. If that is not the thing then the company is heading to ots Death as the big part of  earnings are going from shareholders to BANK or Debentures Trust.

It is not the case with Equity. If the company is not giving the dividend then maybe they are investing it in future growth. Though some investors love to receive dividend more.

There are many aspects for the Ratio. Every industry has it’s own profile and so the need for Capital is different. Infrastructure, Real estate Power need big chunk of Capital. You may find big debt on their Balance Sheet. But about IT company, its difficult for you to find Debt. There is no hard and fast Rule for it that lower the Debt is better. I Know some companies which thrive because of the debt financing at right Time.

Just going to end with the post with statement that if there is no Debt then return on Equity maybe low.

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About Ashutosh Tilak

Tracking Indian Capital Market since 2010. Finance Student, On this blog I am writing about finance and Investing. You can contact me analystashu@gmail.com or @androidashu & @InsideFinanc on twitter