Meaning of Debt Equity Ratio
To decide as to the ratio of various types of securities to total capitalization is a very difficult task but the decision in this important for the business to decide as to the ratio of ownership capital to the creditorship capital or loan capital. The ratio of borrowed capital to the owned capital may be called debt equity ratio. In other words, debt equity ratio is the ratio between borrowed capital on the one hand and owned capital on the other.
Debt equity ratio is positively correlated with the capital gearing. If capital gearing in a company is high, debt equity ratio would also be high or vice versa. For example, if the total capital of Rs. 1,00,000 in a company consists of Rs. 25,000 equity share capital and 75,000 debentures, the debt equity ratio in that company would be 75000 : 25000 or 3 : 1.
Standard Debt Equity Ratio
It is very difficult to fix a standard for the debt equity ratio. It depends very much on the circumstances. However, a standard of debt equity ratio may be 1 :1 but it does not always hold good. In the present circumstances, the debt equity ratio has been on increase.
It increased from 45.8% to 65.5% in 1975. In a developing country like India, where wealth has concentrated in a few hands, the whole of the capital cannot be raised through risk capital because only few have risk bearing capacity and most of the investors want to invest their funds in fixed income bearing securities such as preference shares or debentures. It has become inevitable in these circumstances that company issues debentures to raise the necessary funds for the expansion and modernization of its developmental plans. Also, in order to attract the investing people who prefer fixed income rather than uncertain income, company issues debentures or bonds with attractive terms.
The assumption that low debt equity ratio denotes soundness of the company is not always correct in the present circumstances High debt equity ratio in some companies is not an indication of financial stringency if they are in a position to earn profits at a higher rate than the rate of interest payable on the debt capital. It means they are trading on equity and contributing something towards the funds available for dividend to the equity shareholders. It strengthens the financial position of the company inspite of the fact that company maintains high debt equity ratio.
The nature of the business also affects the standard of debt equity ratio. Financial companies such as banks, insurance companies, and other financial institutions cannot survive without debt capital . Such companies maintain a very high debt-equity ratio. In 1975, the equity ratio of scheduled banks in India was 13000 : 80. Manufacturing companies can maintain a moderate debt equity ratio but a trading company should depend more upon the ownership capital and this should maintain a low debt equity ratio depending upon the nature of fixed capital.
Necessity of Maintaining a Balanced Debt Equity Ratio
A company should always maintain the balanced capital structure that is a proper relation between the amounts raised through various securities. If a company raises funds for most of its capital requirements through various securities.
If a company raises funds for mot of its capital requirements through debt securities, fixed cost of the company will increase and it will prove a burden on the financial position of the company though the company can raise the rate of dividend temporarily through trading on equity. It is, therefore very necessary to maintain the balance in debt equity ratio.