Debt and equity form the essential components of capital employed in business. Equity means the money funded by the promoters or shareholders. Debt in simple terms means loan raised from the lenders. Amount of equity in a business solely depends on the capacity of the promoter(s).
Business promoter has two options to raise the capital – opt for 100% equity or a combination of debt and equity. 100% equity means the business is not functioning on any interest on loan. However, it still carries the cost of capital. On the other hand, business with debt means interests are to be paid on loans.
What is the correct debt equity ratio then? There is nothing called correct debt equity ratio. Financial institutions accept debt equity ratio between 1:2 and 1:1 as reasonable and adequate for business. Higher debt than equity means higher amounts of interest and hence, lower profit margins. Lower amount of debt means less productive use of the funds available.