Capital Structure or Leverage Ratios

The financial strength analysis can be made with the help of the following ratios:

(1)      Debt-equity ratio

(2)      Capital gearing ratio

(3)      Financial leverage

(4)      Proprietary ratio and

(5)      Interest coverage.

Debt-Equity Ratio:

The debt-equity ratio is determined to ascertain the soundness of the long-term financial policies of the company. This ratio indicates the proportion between the shareholders’ funds (i.e. Tangible net worth) and the total borrowed funds. Ideal ratio is 1. In other words, the investor may take debt equity ratio as quite satisfactory if shareholders’ funds are equal to borrowed funds. However, creditors would prefer a low debt-equity ratio as they are much concerned about the security of their investment. This ratio can be calculated by dividing the total debt by shareholders’ equity. For the purpose of calculation of this ratio, the term shareholders’ equity includes share capital, reserves and surplus and borrowed funds which includes both long-term funds and short-term funds.

                                                Debt

Debt-equity ratio      =       -----------

                                                Equity

A high ratio indicates that the claims of creditors are higher as compared to owners’ funds and a low debt-equity ratio may result in a higher claim of equity.

Capital Gearing Ratio: This ratio establishes the relationship between the fixed interest-bearing securities and equity shares of a company. It is calculated as follows:

                                                Fixed interest-bearing securities

Capital gearing ratio  =               -------------------------------------

                                                                                                             Equity shareholders’ funds

Fixed-interest bearing securities carry with them the fixed rate of dividend or interest and include preference share capital and debentures. A firm is said to be highly geared if the lion’s share of the total capital is in the form of fixed interest-bearing securities or this ratio is more than one. If this ratio is less than one, it is said to be low geared. If it is exactly one, it is evenly geared. This ratio must be carefully planned as it affects the firm’s capacity to maintain a uniform dividend policy during difficult trading periods that may occur. Too much capital should not be raised by way of debentures, because debentures do not share in business losses.

Financial Leverage Ratio:

Financial leverage results from the presence of fixed financial charges in the firm’s income stream. These fixed charges do not vary with the earnings before interest and tax (ebit) or operating profits. They have to be paid regardless of the amount of earnings before interest and taxes available to pay them. After paying them, the operating profits (ebit) belong to the ordinary shareholders. Financial leverage is concerned with the effects of changes in earnings before interest and taxes on the earnings available to equity holders. It is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in ebit on the firm’s earning per share. Financial leverage and trading on equity are synonymous terms. The ebit is calculated by adding back the interest (interest on loan capital + interest on long term loans + interest on other loans) and taxes to the amount of net profit. Financial leverage ratio is calculated by dividing ebit by ebt (earnings before tax). Neither a very high leverage nor a very low leverage represents a sound picture. (ebit ÷ ebt).

Proprietary Ratio:

This ratio establishes the relationship between the proprietors’ funds and the total tangible assets. The general financial strength of a firm can be understood from this ratio. The ratio is of particular importance to the creditors who can find out the proportion of shareholders’ funds in the capital assets employed in the business. A high ratio shows that a concern is less dependent on outside funds for capital. A high ratio suggests sound financial strength of a firm due to greater margin of owners’ funds against outside sources of finance and a greater margin of safety for the creditors. A low ratio indicates a small amount of owners’ funds to finance total assets and more dependence on outside funds for working capital. In the form of formula this ratio can be expressed as:-

                                                                              Net Worth

Proprietary Ratio                                                  =    --------------

                                                                             Total Assets

Interest Coverage:

This ratio measures the debt servicing capacity of a firm in so far as fixed interest on long-term loan is concerned. It is determined by dividing the operating profits or earnings before interest and taxes (ebit) by the fixed interest charges on loans. Thus,

                                                                            EBIT

Interest Coverage                                                =  ----------

                                                                           Interest

It should be noted that this ratio uses the concept of net profits before taxes because interest is tax-deductible so that tax is calculated after paying interest on long-term loans. This ratio, as the name suggests, shows how many times the interest charges are covered by the ebit out of which they will be paid. In other words, it indicates the extent to which a fall in ebit is tolerable in the sense that the ability of the firm to service its debts would not be adversely affected. From the point of view of creditors, the larger the coverage, the greater the ability of the firm to handle fixed-charge liabilities and the more assured the payment of interest to the creditors. However, too high a ratio may imply unused debt capacity. In contrast, a low ratio is danger signal that the firm is using excessive debt and does not have the ability to offer assured payment of interest to the creditors.