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Hi Mike !
Hope all is well !Is below statement right/valid ? I have found it from our local textbook
“A debt to equity ratio that is too low usually indicates that the business is not using its cash and profits to obtain business assets. This may discourage investors because it will mean that less profits are distributed to them “
Yes, it could be viewed that way. In the tiger economies in the Far East and also in Germany, it is traditionally the case that business should be heavily financed by other people’s money. That being so, so long as you are able to service the borrowings by interest payments then, as profits rise and interest payments are static, the effect on return available for equity is dramatically increased
Ok?
Not yet Sir. How could it be LOW, while its having heavily long term debts ?
I am missing the point.
I have borrowed $1,000 @ 10% to help to finance my business. In addition I persuaded my immediate family to invest $99,000 and I issued shares to them
When I made $20,000 profit before interest (ignore taxation) that meant that after I had paid the interest, I had $19,900 return for equity. This increase in shareholders’ funds is obviously an increase in assets and that surplus cash is available to be converted into other assets (for example TNCA) or distributed by way of dividend.
If we make a full distribution of the dividend, that would be a return on the shareholders shares of €19,900/$99,000 – a return slightly better than 20%
If alternatively I had borrowed $99,000 from outside lenders and issued only 1,000 shares to family, I still make $20,000 profit before interest.
Pay 10% interest on $99,000 = $9,900 and that leaves $10,100 for the shareholders. If we distribute that $10,100 in full to our 1,000 shareholders, that’s a return on their investment of 1,000%
So even though our financial performance is identical, the debt equity ratio indicates just how dramatic are the consequences of borrowing heavily
Of course, in both cases the profit had been only $5,000 pre interest, then the story is rather different
In case 1) after interest we have $4,900 available for equity whereas in case 2) after interest we have LOSS after interest of $4,900
Coming back to your question, if we have a low debt equity ratio, whose money is the company using to refinance their TNCA? Why, it’s the shareholders’ funds that are being used
Whereas if we have a high debt equity ratio, then we’re using a lot of outside finance to replace our assets.
Is that better?
Sir,
I got you BUT could you check it again the statement“A debt to equity ratio that is too low usually indicates that the business is not using its cash and profits to obtain business assets. This may discourage investors because it will mean that less profits are distributed to them “
I think, there is typing error. Instead of saying “the business is not using its cash…” , they should have said ” the business is using its cash….” am i correct ?
Having Low debt-equity ratio, it means the business is using its shareholder’s funds more to finance the business. And because of this, the business is not in the position to declare dividend as it needs more and more money to finance/expand its operation. Hence, it discourages investors because less profits are distributed to them.
Yes, accepted! It looks like a little negative has slipped in there. Sorry – I was committing the cardinal students’ sin of answering the question that I thought had been asked instead of the one that was asked
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