Does the mixture of debt and equity in a firms financial structure matter why - Essay Example

There must be a certain proportion of debt and equity in the balance sheet of a company. Variation in the debt and equity ratio of the firm can be seen at the arrival of a firm’s tangible assets and the reduction of its intangible asset. A company with large amount of purchased goodwill forms heavy acquisition activities which may end up with forming a negative equity position for the company. Suppose a firm has a long term debt of $3000 and the value of its assets is $12,000, its debt to equity ratio is 0.25. This ratio indicates that the firm’s 25 percent assets have been financed through debt.

If a company debt to equity ratio is greater than one, this means that majority of the firm’s assets have been financed by debt and therefore there are increased chances of bankruptcy. Such firms are considered riskier in terms of investment in the sight of investors and financial institutions. A company with a balanced debt to equity ratio is considered healthy in the eyes of the investors and lenders. The mixture of debt and equity is considered to be important with respect to the firm’s financial structure as it is used as a standard for judging the financial performances of companies.

It measures the ability of the firm to be able to repay its debt or not. If the debt to equity ratio of a firm is increasing this indicates that the firm’s assets are rapidly being financed by the debt rather than the company’s own finances. The lenders and investors would rather give preference to companies with low debt to equity ratio because their interest would be better protected in the case of business decline. Therefore the companies with low financial leverage ratio are able to attract more investors (Debt-to-Equity Ratio).

The optimal financial leverage ratio is 1. This means that all the long term liabilities of a company are equal to its assets. This ratio may vary from industry to industry, as it also