The D/E ratio is an important tool of financial analysis to appraise the financial structure of a fum. It has important implications from the view-point of the creditors, owners and the firm itself. The ratio reflects the relative contribution of creditors and owners of business in its financing. A high ratio shows a large share of financing by the creditors of the firm; a low ratio implies a smaller claim of creditors. The D/E ratio indicates the margin of safety to the creditors. If, for instance the D/E ratio is 1 : 2, it implies that for every rupee of outside liability, the firm has two rupees of owner’s capital or the stake of the creditors is one-half of the owners. There is, therefore, a safety margin of 66.67 per cent available to the creditors of the firm. The firm would be able to meet the creditors claims even if the value of the assets declines by 66.67 per cent. Conversely, if the D/E ratio is 2 : 1, it implies low safety margin (one-third) for the creditors.
If the D/E ratio is high, the owners are putting up relatively less money of their own. It is danger signal for the creditors. If the project should fail financially, the creditors would lose heavily. Moreover, with a small financial stake in the line, the owners may behave irresponsibly and indulge in speculative activity. If they are heavily involved financially, they will strain every nerve to make the enterprise a success. In brief, the greater the D/E ratio, the greater is the risk to the creditors.
A high debt-equity ratio has equally serious implications from the firm’s point of view also. A high proportion of debt in the capital structure would lead to inflexibility in the operations of the first as creditors would exercise pressure and interfere in management. Secondly such a firm would be able to borrow only under very restrictive terms and conditions. Further, it would have to face a heavy burden of interest payments, particularly in adverse circumstances when profits decline. Finally, the firm will have to encounter serious difficulties in raising funds in future.
The shareholders of the firm would. However, stand to gain in two ways: (i) with a limited Slake. they would be able to retain control of the firm and (ii) the return to them would be magnified. With a larger proportion of debt in the financial structure, the earnings available to the owners would increase more than proportionately with an increase in the operating profits of the firm. This is because the debt carries a fixed rate of return and if the firm is able to earn on the borrowed funds a rate higher than the fixed-charge on loans. the benefit will go to the shareholders. This is illustrated in Technically, this is referred to as leverage of trading on ,equity. The expression trading on equity describes the practice of using borrowed funds carrying a fixed-charge in the expectation of obtaining a higher return to the equity-holders. The leverage can, of course. work in the opposite direction also if the return on borrowed funds is less than the fixed charge
A low D/E ratio has just the opposite implications. To the creditors a relatively high stake of the owners implies sufficient safety margin and substantial protection against shrinkage in assets. For the company also, the servicing of debt is less burdensome and consequently its credit standing is not adversely affected, its operational flexibility is not jeopardized and it will be able to raise additional funds. The shareholders of the firm are deprived of the benefits of trading on equity or leverage.