Question

You plan to purchase debenture bonds from one of two companies in the same industry that are similar in size and performance.

The first company has $350,000 in total liabilities and $1,750,000 in equity.

The second company has $1,200,000 in total liabilities and $1,000,000 in equity.

What does the debt to equity ratio measure and how is it interpreted?

Which company's debenture bonds are less risky based on the debt to equity ratio, calculated as total liabilities/ total equity?

Answer 1

Debt Equity Ratio is the Ratio of Debt for Equity. Let us calculate the Debt Equity Ratio for both the companies given:

For First Company:

1. Debt: $350000

2. Equity: $ 1750000

So, Debt Equity Ratio is 0.2:1

For Second Company:

1. Debt: $1200000

2. Equity: $ 1000000

So, Debt Equity Ratio is 1.2:1

Idle Debt Equity Ratio is 1 to 1.5 Debt per 1 Equity. As an investor , I would like to go with Company 2 as they are less risky due to lesser control of Equity Holders and by deploying better portion of Debt than Equity. Always Debt Funds has more advantages than Equity Funds. That is why it is better to have good portion of Debt in the Funding.

Happy Learning and All The Best..