DEBT RATIO Definition

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DEBT RATIO measures the percent of total funds provided by creditors. Debt includes both current liabilities and long-term debt. Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors losses in liquidation. Owners may seek high debt ratios, either to magnify earnings or because selling new stock would mean giving up control. Owners want control while "using someone elses money." Debt Ratio is best compared to industry data to determine if a company is possibly over or under leveraged. The right level of debt for a business depends on many factors. Some advantages of higher debt levels are:

  • The deductibility of interest from business expenses can provide tax advantages.
  • Returns on equity can be higher.
  • Debt can provide a suitable source of capital to start or expand a business.

Some disadvantages can be:

  • Sufficient cash flow is required to service a higher debt load.
  • The need for this cash flow can place pressure on a business if income streams are erratic.
  • Susceptibility to interest rate increases.
  • Directing cash flow to service debt may starve expenditure in other areas such as development which can be detrimental to overall survival of the business.

 Formula: Total Liabilities / (Total Liabilities + Stockholders Equity)

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NOMINAL RETURN is an investment return that does not take into account the effects of inflation on the investment or return.

RECAPITALIZATION: It is dependent upon how you use the term. The term recapitalization in itself is, dependent upon the scenario, simply an adjustment of the relationships between the debt and equity that funds a firms assets. However, it can become quite complex dependent upon under what conditions or reasons the firm is being recapitalized. This is especially true if recapitalization is being pursued to ward off a hostile takeover.

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