ACC501 Business Finance GDB Solution 2018

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?