The capital structure is a company’s structure that includes a mix of equity financing and debt financing.
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 affects 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 well-established, it may take more of its earnings to satisfy its interest payments and thus have less to invest in growth.
Capital Structure Ratios
Capital structure ratios may be defined as those financial ratios that measure the firm’s long-term stability and structure.
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. These ratios indicate the mix of funds provided by the owners and lenders and assure the lenders of the long-term fund concerning:
Objectives and Types of Capital Structure Ratios
The primary objective of capital structure ratios is to measure a company’s financial risk, profitability, and solvency, which can help investors and analysts make informed decisions about investing in or lending to the company.
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:
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 provides an indication of how much of a company’s assets are financed by debt. The formula for calculating the debt ratio is:
Debt Ratio = Total Debt / Total Assets
For example, if a company has total debt of $2 million and total assets of $10 million, the debt ratio would be:
Debt Ratio = $2,000,000 / $10,000,000 Debt Ratio = 0.2 or 20%
This means that 20% of the company’s assets are financed by debt. Investors and analysts use the debt ratio to assess a company’s leverage and risk profile. A higher debt ratio indicates greater financial risk, while a lower debt ratio indicates a more conservative financial position.
Debt to Equity Ratio
The debt-to-equity ratio is a financial ratio that compares a company’s total debt to its total equity. It measures the degree to which a company is using debt to finance its operations and the extent to which shareholders’ equity is available to cover potential losses.
The formula for calculating the debt-to-equity ratio is:
Debt-to-Equity Ratio = Total Debt / Total Equity
For example, let’s say Company XYZ has total debt of $1 million and total equity of $3 million. The debt-to-equity ratio for Company XYZ would be:
Debt-to-Equity Ratio = $1,000,000 / $3,000,000 Debt-to-Equity Ratio = 0.33 or 33%
This means that for every $1 of equity, Company XYZ has $0.33 of debt. A debt-to-equity ratio of 33% is generally considered healthy, indicating that the company is not overly reliant on debt to finance its operations.
However, it’s important to note that a healthy debt-to-equity ratio can vary by industry and company. Some industries, such as utilities and telecommunications, typically have higher debt-to-equity ratios due to the large capital investments required to operate in those industries. In contrast, companies in industries with low capital requirements, such as software or consulting, may have lower debt-to-equity ratios.