Conversation about Debt Equity Ratio

Manu

Hi Vinu! You look puzzled! What’s the matter?

Vinu

I would like to know more about Debt Equity Ratio – Banker’s says that our fundamentals are very weak due to Higher Debt Equity Ratio – can you explain me what does that convey?

Manu

Sure Vinu.  Let’s assume you start a business with an investment of Rs.10 Million.

Vinu.

Ok.

Manu

Now the question is how you are going to fund this investment of Rs.10 Million. You have choices in selecting funds right?

Vinu

Yes! Funds can be raised through

1. Owners Funds (Equity);
2. Outsiders Funds (Loan / Debentures)

Manu

Good! If you raise more funds through Owners funds and less funds from Outsiders funds, then your business is said to be more stable one.

Vinu

How is that?

Manu

Let’s have a look at this balance sheet:

In this balance sheet, the role of debt funds is only 10% total funds. Equity shareholders have contributed 90% of the funds.

Vinu

Agreed!

Manu

Can you calculate the Debt Equity Ratio for this scenario?

Vinu

Ya!

Debt  - 10

Equity – 90

Debt to Equity Ratio = Debt / Equity  = 10 / 90 = 0.11:1

Manu

You are right. In this case, Debt is only 11 Paise for every One Rupee of Equity. This means, this company is not dependent on the outsiders for running its show.

Vinu

True.

Manu

Let’s assume, this company defaults in repayment of its debt of 10. The lenders need not worry a lot, because this company has got assets worth 100. Even if you take distressed sale value of saleable assets at 50%, it is 50, and so the lender’s interest is protected because his loan is only 10.

Vinu

Very True. In the event of default, lenders have fall back in case of low debt equity ratio borrowers.

Manu

Yes. Now, let’s change our Balance Sheet:

Did you noticed the equity and debt amount?

Vinu

Ya. Now Equity is only 20 whereas Debt is 80.

Manu

It means, 80% of funds for this business comes from lenders and only 20% were contributed by equity shareholders.

Vinu

So their Debt Equity Ratio should be like this:

Debt  - 80

Equity – 20

Debt to Equity Ratio = Debt / Equity = 80/20 = 4:1

Manu

That’s correct – D/E Ratio is 4:1. If your company’s Debt Equity Ratio is in this range, then don’t expect banker to support you.

Vinu

Why?

Manu

Ratio of 4:1 indicates Debt is 4/5= 80% and Equity is 1/5=20%.

You are running the business mainly with the support of Bank Funds.

Vinu

So what?

Manu

Let’s say, this company defaults in loan payment – what was the loan amount?

Vinu

It is 80.

Manu

Assets available?

Vinu

100

Manu

So, now lenders have fall back on assets worth 100 for a loan of 80. Bankers should be comfortable right?

Vinu

Yes.

Manu

But Banker’s cannot be. Generally, market reacts negatively when Bankers try to sell possessed assets.

Vinu

How?

Manu

If the realisable value of asset is 100, but if it is getting sold by Banker through possession on account of default, then buyers in the market will try to take advantage of it and will pitch for least possible price. It will be technically called as forced sale value.

Vinu

Oh….

Manu

In this case, it is possible asset with Realisable Value of 100, may get sold in the market at Forced Sale Value for just 50 (i.e., 50%  Forced Sale Value)

Vinu

Oh..So the Bank will suffer loss of 30?

Manu

Yes! They have given a loan of 80 and what they are going to recover is only 50 and eventually suffer a loss of 30. So they try to stay away from companies with high debt equity ratio.

Vinu

But, what is the problem in that, if I honour my commitments regularly?

Manu

No problem if you can honour your commitment regularly. But the point you have to keep in mind is Bank Funds are liabilities that comes up with Fixed Cost. i.e., Interest and Principal repayment should be as per repayment schedule.

Vinu

So?

Manu

Just visualise what will happen to your profit, if your sales drops by 5%.

Vinu

My Profit will also fall by 5%

Manu

That will happen only when all your costs are variable costs. (i.e., Costs should move along with sales.)

Vinu

Correct!

Manu

No business will have only variable cost. For sure there will be certain element of Fixed Cost (like Salary, Rent, Power, Interest, etc.) and in this case Interest on Debt is a Fixed Cost.

Vinu

Agreed!

Manu

It may so happen, when your sales drop by 5% and if you have more fixed costs, your profit can fall by 25%. If you are in thin Profit margin business, then small change in sales will erode all profits and result in losses.

Vinu

Understood.

Manu

Now let’s go back to Banker’s point of view. Banker’s understand more debt means more fixed cost and small variation in sales would make your company as loss making company.

Vinu

Very true.

Manu

And if your company suffers loss, the immediate impact is going to be on bankers. Their cash flows dependent on your company is affected.

Vinu

Correct!

Manu

So, Bankers won’t create this situation for themselves and eventually suffer loss. Rather they try to stay away from these kinds of companies.

Vinu

Oh…that’s why they are avoiding companies with high debt equity ratio?

Manu

Yes! It’s actually good for both.

Vinu

Do they have maximum level for Debt Equity Ratio?

Manu

It varies from Bank to Bank. Theoretically Debt to Equity Ratio of 2:1 is considered as maximum.

Vinu

i.e., Debt 2/3=67% and Equity 1/3=33%

Manu

Correct! But in practice, the maximum level practiced by bankers are 3:1

Vinu

Oh…Debt of 3/4=75% and Equity 1/4=25%

Manu

Yes! In Banking language Debt Equity Ratio is also called as TOL / TNW and they refer it as Leverage.

Vinu

What was that?

Manu

TOL – Total Outside Liabilities

TNW – Tangible Networth

Vinu

So, in Debt Equity ratio, debt means Total Outside liabilities?

Manu

It depends upon the context. If you are calculating Debt Equity ratio for the company as whole, the Debt means Total Outside Liabilities.

Vinu

Ok!

Manu

If you are calculating D/E Ratio for a Capex Project, then Debt would mean only the long term funds that comes into the project.

Vinu

Ok! Got it. Thanks Manu for detailed Insight.

Manu

Welcome Vinu.