Equity and Debt – Most important concept of Investment Banking
Investment banking comprises of helping companies issue debt and equity and thus it is not only important but mandatory to familiarize with these concepts. If the level of debt is increased in any firm’s capital structure, it becomes quite beneficial for the firm. On the other hand, if the amount of leverage is increased in any firm, it entails a higher interest payment thereby leading the firm to a possible bankruptcy during poor economic times. Debt and Equity are two simple financial terms we already know. Let us understand how crucial they become together in investment banking.
Understanding debt-to-equity ratio
Debt-to-equity ratio is a financial metric generally used to assess a company’s capital structure or its capital stack. It measures the relative proportion of the firm’s assets that are funded by debt or equity.
Debt to Equity ratio = (Firm’s total debt) / (Shareholder equity)
If this ratio is less than 1 for any company, it simply shows that the company has a low amount of debt and is therefore exposed to less risk in terms of interest rate increases or credit ratings.
Significance of Debt and Equity in Investment Banking
A high debt equity ratio for any firm suggests that it has been aggressively funding its growth with debt and this may result in volatile earnings. A high or low debt to equity ratio for any firm may or may not lead to benefits for the shareholders depending upon how the company is earning. Moreover, debt equity ratio also varies from industry to industry.
A capital-intensive industry firm such as auto manufacturing usually has a debt equity ratio of above 2 and still does well. On the other hand, software companies having a debt ratio or even 1 would not be considered a safe bet.