If I put it in the simple words the debt is the amount of money that you owe or borrow from another party like a bank, NBFC or any financier. You are obliged to repay the principal amount along with the interest fee (a certain percentage of the principal amount which is mutually agreed) paid at regular intervals of time like monthly, semi-annually or annually. While the equity is that part of the asset which you own without any obligation to return and re- pay and there is no interest fee charged on that value.
The meaning of this ratio
The D/E value indicates the extent to which a company is using debt as a means to finance its operations and other projects in order to grow in size. A high D/E generally indicates the aggressive nature of the company with high level of risk attached to it.
And the complete onus for this lies on the shoulders of the management team; a right mix of timing and the amount of leverage further decides the growth trajectory of the company.
Let us understand the importance and the significance of this ratio with the help of the following examples:
Suppose, you have equity of Rs. 50,000 and you decide to invest this amount in your business and expect an annual return of 10% on this investment. Your annual income at this rate will be (10% of Rs. 50,000) Rs. 5,000. In this case, you do not have any proportion of debt that is the debt amount is zero.
In this case, your D/E ratio will be zero.
Now, further suppose that you decide to add Rs. 25,000 (50% of the Equity) as a debt, then your combined debt – equity structure becomes Rs. 50,000 + Rs. 25,000 = Rs. 75,000 with D/E ratio of (Rs.25,000/Rs.50,000) = 0.5. You have borrowed Rs. 25,000 at an interest rate of 10% per year; it means that you will be paying Rs. 2,500 per year as an interest (obligation). You decide to invest Rs. 75,000 in your business and expect that your income will be 10% of the total amount invested that is (10 % of Rs. 75,000) Rs. 7,500.
Your Net income, in this case, would be:
Rs. 7,500 – Rs. 2,500 (Interest Obligation) = Rs. 5,000
Now considering the different Debt – Equity structure as shown in the following table:
Case 1: When your Expected rate of Annual Return on the total investment (Er) = Rate of Interest on the debt amount (Ir)
It will be Rs.5,000 when I use no debt. Moreover, when I use debt, my obligation will be constant every year in the form of interest fee but my return can vary, it may go up (good) or may down (bad). If it goes down then my net income will also reduce, in that case how I will manage to run my daily operations?
Case 2: When your Expected rate of Annual Return on the total investment (Er) < Rate of Interest on the debt amount (Ir)
The reason is simple when Er < Ir then my net income will decline continuously with the increase in the debt portion into my total investments.
Case 3: When your Expected rate of Annual Return on the total investment (Er) > Rate of Interest on the debt amount (Ir)
But next moment, on deeply analyzing the situation I found that my obligation is constant which I have to pay every year without any delay & default otherwise, the other party has all rights to get me penalized through court. Whereas my expected returns are not confirmed or certain, it may go down or up.
Consider the case when Er goes down, say by 20%, that from 12% to 9.6% (80% of 12%)
Criterion for taking the debt
What should be the appropriate D/E ratio for any company?
Well, this question does not have any specific answer; a company with no debt may not perform while the other company with an element of debt in it may be performing very well. Manufacturing companies and other capital intensive companies like the automobile companies which require a heavy investment before starting the business, generally have D/E > 2. The information technology company does not require that amount of capital to start off because initially, a few computers with an internet connection can be sufficient to take off the venture.
Which are companies more inclined towards debt?
Small and the mid-sized companies which are expecting higher growth rate, at least more than 50% of the interest on the Debt amount. But before investing in small and mid-sized companies, one should look that these companies must have at least 5 years of operations in the business so that one can analyze their performances by looking at their relevant ratios and the cash flow statements.
As these companies start growing in size their growth rate starts declining and subsequently they start relinquishing the debt portion from their investment. Finally, there comes a stage when these healthy companies become cash cows and start generating constant cash flows; however, the percentage of the return comes down.
The above findings can be summarized in the following table:
Although using and adding debt in your investment adds a portion of the risk in the business but a right timing with the right amount of leverage can definitely accelerate the growth of the company which otherwise is difficult with equity only. However, the D/E equity ratio is the relative term, means that there is no constant value for all the companies. A relatively high D/E is considered okay in the capital intensive industry while in other industry like IT, computer etc, a low D/E ratio is quite common. The main point to consider that growth rate of the company must be greater than the interest rate of the debt with the right margin of safety.