Question

The directors of a manufacturing company are thinking of issuing Rs. 20 lacs additional debentures for expansion of their production capacity. This will lead to an increase in debt-equity ratio from $2:1$ to $3:1$. What are the risks involved in it? What factors other than risk do you think the directors should keep in view before taking the decision?

Answer 1

A debt-to-equity ratio measures the amount of debt a company uses to fund its business for every dollar of equity it has. The ratio equals total liabilities divided by total stockholders’ equity, which are found on the balance sheet. The higher the ratio is, the more debt a business uses compared to equity. A ratio that is too high can potentially cause problems in your small business.

Defining a High Debt-to-Equity Ratio

Acceptable debt-to-equity ratios differ among industries. In general, a ratio that is greater than the industry average is too high. For example, if your small business has Rs-400,000 in total liabilities and Rs 250,000 in total stockholders’ equity, your debt-to-equity ratio is 1.6. This means you use Rs 1.60 in debt for every Rs 1 of equity, or your debt level is 160 percent of your equity. If the industry average is 0.9, you have a high debt-to-equity ratio.

Directors should keep in view before taking the decision-

Reduced Ownership Value

Liabilities and equity represent the respective claims that creditors and owners have on a company’s assets. A high debt-to-equity ratio reduces the value of owners’ stake in a business as a proportion of its assets. If your small business has a high debt-to-equity ratio and you sell or liquidate the company, you would have to distribute a larger portion of the proceeds to creditors than if you had a low debt-to-equity ratio.

Increased Risk

The risk of defaulting on, or being unable to repay, your debt increases as your debt-to-equity ratio rises. A reasonable amount of debt can help you grow your small business, but too much can overburden you with high-interest payments. You have to generate more business just to break even. If you fail to make these interest payments, creditors might take your company’s assets or force you into bankruptcy.

Trouble Obtaining Additional Financing

Banks typically require a low debt-to-equity ratio when they extend new credit. Because a high debt-to-equity ratio reduces a bank’s chances of being repaid, it might refuse to provide additional funding or might give you money only with unfavorable terms. Say your debt-to-equity ratio is 2 and the bank’s cutoff is 1.5; it would likely deny you a loan.

Violating Debt Covenants

Loan agreements often include covenants, which are stipulations that require a business to do or not do certain things, such as maintain adequate financial ratio levels. If your debt-to-equity ratio exceeds that allowed by a covenant with an existing lender, the lender might call your entire loan due. For example, if an existing lender requires you to keep your debt-to-equity ratio below 1.8 and it jumps to 2.1, you would violate the covenant.