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Debt Vs Equity – Arriving at the Right Ratio

Debt Vs Equity – Arriving at the Right Ratio

A regular assessment of debt vs equity is of paramount importance for all businesses. In the case of a small business venture, this assessment becomes imperative as it helps in your long-term financial decisions-making.

Let’s then find out in greater detail about both the components, debt and equity, and what picture they can show of the business when seen together.

What is Debt and Equity?

As the name suggests, debt is what your business owes to external creditors. It includes include all debts/liabilities to outsiders, whether long term or short term or whether in the form of bonds, mortgages or bills.

On the other hand, equity is the fund that you have brought into your venture. And includes capital, accumulated profits, contingency funds, funds created to replace assets etc.

What is Debt-Equity ratio and how is it calculated?

Debt-Equity ratio is the relationship between the external debt and the internal funds of your business. This is a measurement of how much suppliers, lenders, creditors and obligors have committed to the business versus what you as a proprietor/partner have committed.

It is calculated as follows:

Debt-Equity Ratio = External Debt/Internal Funds

Ideal Ratio:

A ratio of 1:1 is usually considered to be satisfactory. However, there is no rule of thumb or standard norm for all types of businesses. Theoretically, if the owner’s interests are greater than that of the creditors, the financial position is highly solvent.

• A ratio of less than 1:1 means:
o Owner’s equity is more than debt
o The owner is bearing more risk in the business than the external creditors
o The owner has a strong financial interest in the business

• A ratio of more than 1:1 means:
o Owner’s equity is less than debt
o The owner is bearing less risk in the business than the external creditors
o The external creditors have a strong financial interest in the business than the owner

Interpreting Deb-Equity Ratio:

Since the debt-equity ratio indicates the proportionate claims of owners and the outsiders against the firm’s assets, it’s purpose is to get an idea of the cushion available to outsiders on the liquidation of the business.

Often, the interpretation of the ratio depends upon the financial and business policy of the business concern –

• The owners want to do the business with maximum of outsider’s funds in order to take lesser risk of their investment and to increase their earnings by paying a lower fixed rate of interest to outsiders.
• The outsider’s (creditors), on the other hand, want that the owners should invest and risk their share of proportionate investments.

Finally, too much debt can put your business at risk and indicates possible difficulty in meeting interest and principal repayments. While, too little debt may suggest you are not taking advantage of opportunities and realise the full growth potential of your business.

Debt Vs Equity – Arriving at the Right Ratio

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