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Discussion Question:

 

Debt-equity (D/E) ratio indicates that how many times a corporation has external funds in comparison to its equity (internal funds). Generally, corporations try to maintain this ratio up to a reasonable range to be in sound financial position. A better D/E ratio ensures better-paying capacity of both principal and the interest.

 

Different industries have different benchmarks for this ratio.  For example, technology corporations have an industry standard of 2 times whereas manufacturing companies tend to have this particular ratio between 2 to 5 times. However, a higher ratio is considered favorable in case of banking and other development finance institutions (DFIs).

 

On the contrary, banks impose limitations on corporations while granting loans (through bank loan covenants) on the maximum debt-equity ratio.

 

You are required to discuss the following:

a) Why is a high debt-equity ratio of banks considered as favorable?

b) Why banks put limitations on the maximum D/E ratio of companies while sanctioning loans?


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Replies to This Discussion

Question#1:-

                      Why is a high debt-equity ratio of banks considered as favorable?

Answer:-

                 A high debt-equity ratio of banks considered as favorable because

  • The debt/equity ratio is a leverage ratio that represents what amount of (money owed)  and equity is being used to finance a company's valuable things
  • A bank can never give it’s optimal capital structure to his economy
  • The debt/equity ratio is carefully thought about/believed a key (money-related) metric because it points to/shows potential (money-related) risk. 
  • Companies have an optimal capital structure.

Question#2:-

                     Why banks put limitations on the maximum D/E ratio of companies while sanctioning loans?

Answer:-

  • The debt/equity ratio commonly points to/shows an aggressive growth plan by a company.
  • For this means potential increased with a similarly increased risk of loss.
  • Reduce the risk of absence of financial detail.
  • Banks carry greater amount because the money they borrow is also the money they lend.

very well done 

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