Financial Accounting

What are capital structure ratios in accounting?

What is Capital Structure?

Capital structure is the financial structure of a company, involving its balance sheet, debt and equity. The primary objectives of capital structure are debt financing and financing equity capital.

The major purpose of having a capital structure with high equity is to provide flexibility in terms of the size of a business, its ability to deal with fluctuating revenues, and the cost of capital that is involved.

The three sections of the capital structure are equity, debt, and preferred stock. The ratio between debt and equity has a significant bearing on how financially healthy a company is. Companies with a higher debt ratio are likely to struggle while companies with a lower debt ratio are most likely to have stronger finances.

The capital structure is a key determinant of a firm’s financial performance and, to a certain extent, its long-term profitability and survival. High leverage tends to cause firms to take on more risk, so firms with high leverage, especially those with greater than 100% leverage, are more exposed to the downside of poor market conditions or negative cash flows. Conversely, capital structure is less important to short-term profitability, though capital structure also has an effect on capital markets.

There is no consensus on the optimal capital structure. The high levels of leverage found in most developed economies would suggest that there is a relationship between risk and return, but the opposite is also possible. If the firm is very well-established, it may take more of its earnings to satisfy the interest payments it makes and thus have less to invest in growth.

Capital Structure Ratios

The capital structure is a company’s structure that includes a mix of equity financing and debt financing. Capital structure ratios are used to measure a company’s capitalization.

In accounting, there are many different ratios used for this purpose. The ones most commonly reported range from debt-to-equity, current assets to current liabilities, and long-term debt as a percentage of assets. However, not all of these ratios are used or relevant to a company’s financial health.

Capital structure ratios are also known as leverage ratios. Capital structure ratios may be defined as those financial ratios that measure the firm’s long-term stability and structure.

These ratios indicate the mix of funds provided by the owners and lenders and assure the lenders of the long-term fund concerning:

a. Periodic payment of interest during the period of the loan and

b. Repayment of principal amount on maturity.

Hence, leverage ratios are of two kinds:

i. Capital structure ratios and

ii. Coverage ratios

Objectives and Types of Capital Structure Ratios

These ratios give an insight into the financing approaches utilized by the organization and focus on the long-term solvency situation.

One can acquire just the absolute funds used and their sources from the balance sheet, but they do not transmit any significant information regarding their proportion to another sort of source of funds.

For example, the Debt ratio is utilized to discover how much debt is in total capital employed.

There are three main types of capital structure ratios:

Equity Ratio

The equity ratio is a way for a bank or company to determine how much of its funds are financed by stockholders instead of debt holders. It represents the percentage of the firm’s total capital raised from shareholders instead of borrowed capital. The higher the equity ratio, the better for shareholders because it means they own a greater percentage of the company and that other sources of financing are not needed.

It indicates the proportion of owners’ funds to the total funds invested in the business. The old law school believed that more equity is safe for the firm and that there should be more equity in the total capital.

The formula of Equity Ratio = Shareholders’ Equity / Total Capital Employed.

Debt Ratio

It is computed as Total debt/ Capital employed. Here, total debt includes short-term and long-term debt, borrowings from financial institutions, bonds, debentures, and bank borrowings. In short, it consists of every type of external funding apart from equity.

Debt to Equity Ratio

The debt-to-equity ratio measures how much a company owes to its shareholders instead of borrowing from banks, institutions, or other outside sources. This ratio helps understand the company’s risk level and financial stability.

A ratio of less than 1 means that the company is more indebted than it is indebted to shareholders; likewise, if the ratio exceeds 1, this would mean that the company gives more money to investors than it borrows.

It is computed as

Debt+Preferred Long Term/ Shareholders’ Equity

Here, preferred stock capital is also added to debt because we compare equity shareholders. A preference share is non-debt security, but they get preference like creditors during capital repayment. Hence, it is assumed as external capital.

Capital Structure Ratios Vary

Several published research reveals that capital structure ratios vary substantially among industrial classifications. For example, random samplings of common equity ratios of big retail corporations tend to differ significantly compared to equivalent numbers of steel producers.

Businesses operating in the same sector tend to display capital structure ratios that cluster around a central value, often known as industry-standard ratios. Because business risk differs from industry to industry, industry ratios tend to vary.

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