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Why excess DER is not recommended ?

DEBT TO EQUITY RATIO 

Debt to equity is a financial liquidity ratio that measures the total debt of a company with the total shareholders’ equity. It helps in determining  if the company is using equity financing or debt financing to run its operations.

The Debt to Equity ratio is also referred to as a leverage ratio which aims at determining how much capital comes in the form of debt, or the ability of a company to meet its financial obligations.

CALCULATION OF DEBT TO EQUITY RATIO –

The formula for calculating the Debt Equity Ratio is as –

Debt Equity Ratio = Total Liabilities / Shareholder’s Equity

Total Liabilities :- Here all the liabilities that a company owes are taken into consideration including both short-term and long-term debt.

Shareholder’s Equity :- Shareholder’s equity represents the net assets that a company owns.

INTERPRETATION OF DEBT EQUITY RATIO

The benchmarks for debt to equity ratios are different depending on the industry because some companies require more debt to meet their financial requirements as compared to others.

An ideal debt/equity ratio is around 1:1 which means equity must be equal to liabilities thereby indicating a favourable financial position of the firm.

A high debt to equity ratio indicates that the company is borrowing more than using its own money which is in deficit and a low debt to equity ratio tells us that the company is using more of its own assets and lesser borrowings.

WHY HIGH DEBT EQUITY RATIO IS NOT SUITABLE ?

A high D/E ratio is usually not recommended and is considered risky for lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing.

In addition to this, a higher D/E ratio may make it harder for a company to obtain financing in the future. This means that the firm may have a harder time servicing its existing debts. Very high D/Es can be indicative of a credit crisis in the future, including defaulting on loans or bonds, or even bankruptcy.

Therefore, if the DE ratio of a company exceeds 1 , the financial controller must take measures to bring down the ratio so as to make it easier for the company to obtain the loan or extend the credit term from its suppliers.

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