Synthesis Analysis:
When business is growing perfectly, additional leverage can fuels more growth, as higher ROE in all cases.
However, when business is not growing as planned like #3 and #4, they made fewer profits thus less going into equity. D/E ratio is all higher than #1 and #2.
When a company is facing more headwinds – like what happened in 2020 – it might suffer further losses. In #5, the company still grows perfectly. So for case B, their D/E is at 0.93 meaning equity is barely enough to repay their debt.
But in #6, the company might very well grow slower – even case B the D/E is 1.03. This is the time when equity is less than what they need to repay debts. One the bank calls back the loan, the company will collapse.
Equity Buffer – entrepreneur view
As an entrepreneur, you should pray for the best but prepare for the worst. Bad things like COVID-19 happens, and one can suffer much more losses than the example above. Better equity buffer exists, the better chance the company will survive, and then prosper – That’s exactly what shareholders, investors and company management always pursue.
A good company will always quantify their equity buffer and dynamically adjust to its view on future volatilities and risks. And for a company that is doing well will naturally have a high equity buffer.
As shown in the following, whenever you are going to jump high, you need always pre-setup the right/strongest “safety net” – equity buffer in the right place. Only that can prevent your free fall and bounce you back even higher.
Equity Buffer – banks view
Banks need to assess a company’s equity buffer thus knowing how much losses can a company take. To lend, or adding to the company’s debt, banks need to ensure that the company does not “drop” debt down first, but maintain a sufficient equity buffer.
Banks might expect a company to hurt its equity buffer. For example, a company has a D/E ratio of 0.1 – however, most of their trade is with related parties. For any reason, if related parties stopped business at any time and never payback, they will still collapse. So the company’s equity buffer is much weaker than D/E suggested.
Bank can also enhance the equity buffer by structuring the facility better, e.g. with collateral. For banks, if the collateral (a mortgage for example), can well cover the bank’s exposure at any time – to the bank, the company’s equity buffer is actually stronger.