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What is the optimal balance between equity and debt for you 3 ways to check.
For companies, a crucial statistic they keep a keen eye on is the debt and equity ratios of the company. If a firm wants to survive, it must maintain a sustainable capital structure that will allow it to sustain itself in the long run and too much debt will inevitably mean suppressed profits due to high amounts of interest payments. This concept doesn’t change very significantly when it comes to individuals. Our economic and financial doings and happenings rely on an influx and outflow of money; investing, borrowing; expenditure and savings. All these have to be made sustainable. If this is the case for all individuals, then what is the optimal balance between debt and equity and how do you check? This article will delve deeper into the search.
Debt to equity ratio
An individual’s debt to equity ratio takes into account their monthly income and debt to ascertain a percentage value. If the individual is Rs. 50,000 in debt and currently possesses Rs. 50,000 to his name, then his debt to equity ratio would be 1, wherein debt = equity. If an individual has outstanding debt of Rs. 20,000 rupee debt and has Rs. 60,000 to their name then their debt to equity ratio would be at 0.33 or 33%..
Ways to check your optimal debt to equity ratio.
There are a number of things you should take into consideration while deciding what the best debt to equity ratio ratio for you is. Here are three ways to check.
1. Consider your investment portfolio : In order to establish the optimal balance between debt and equity for you, you must first take into account where you are deriving your income from, and how much.
For example, if you currently derive 30% of your income from your equity investments and 70% from your fixed income, then you could afford to have a higher debt to equity ratio, as you can guarantee repayments. If however, you derive 70% of your income from your equity investments and only 30% from your salary, then it would be wise to maintain a lower debt to equity ratio, as income from stocks is not guaranteed and involves exponentially higher risk.
2. Adjust to present value : Adjusting the present value of your assets and net worth might help you ascertain your optimal capital structure between debt and equity. You can also check the effect that debt has on your equity structure. For instance, possessing more debt makes borrowing harder. If an individual is in a situation wherein they have taken out a personal loan to hedge their credit card bill against, then taking on more debt will increase the interest rates of their personal loan, effectively making it harder to borrow. In this instance, a lower debt to equity ratio is better.
3. Consider which point in the lifecycle you are : Much like companies, individuals also have financial life cycles. In order to pick the optimal capital structure for you, you would benefit from taking which part of the cycle you are in into account. If you are in the earlier stages of your financial life cycle, then it might be okay to have a higher debt to equity ratio as you have a lot of time left to repay and debt. If you are in the latter sections however and are about to or thinking about retirement, it would make sense to maintain a lower debt to equity ratio since you are focused more on saving for retirement and not on repaying debt.
Taking on debt is something most individuals have to do in order to be financially successful. However, the main goal is to maintain a good balance between debt and equity. There are a number of factors that contribute to the best debt to equity ratio for you, as it is a variable dependent on a multitude of factors, some of which we have discussed and analysed. While taking on debt might allow for opportunities you might not be able to fund yourself, it is always important to make sure you do not bite off more than you can chew.