Evaluating a Company’s Capital Structure using Ratios

A business organization may be financially sound today but it may loose strength tomorrow because of losses. Therefore it is necessary to maintain a judicious balance between the owned capital and borrowed capital. The following ratios have been calculated to analyze the capital structure of a company.

1. Capital Gearing Ratio

Capital Gearing Ratio of an organization measures the relationship between equity share capital to preference capital and loan capital. ‘Capital gearing’ refers to the ratio between the variable cost bearing capital and fixed cost bearing capital of the organization and helps to frame the capital structure of the organization. Capital gearing may be of three types:

  1. High Gearing Capital, which indicates the excess of interest bearing long-term finance over the equity funds;
  2. Low Gearing Capital, which indicates the excess of equity funds over the interest bearing long-term finance; and
  3. Evenly Geared, which indicates the equality between the interest bearing long-term finance and equity funds.

As regards the role of capital gearing in the successful operation of the organization, it is as significant as the use of gears in the speed of an automobile. Just as gears are used in an automobile for maintaining the speed because an automobile starts at low gear and when it start running fast, in the same way when an organization is incorporated, it is begun with more equity capital and less interest bearing finance. But as the business moves ahead, fixed cost bearing finance such as preference capital, debentures and term loans etc., increases and the equity capital either remains constant or increases at a very low speed. High gearing may remain beneficial only when profits are huge and the interest burden fall on profits. Capital gearing is studied with the help of the following formula:

Capital Gearing = Variable cost bearing capital / Fixed cost bearing capital

Here variable cost bearing capital signifies the amount of equity capital plus the amount of retained earnings and other undistributed profits minus intangible assets. Fixed cost bearing capital includes debentures and long-term loans.

2. Current Liabilities to Net Worth Ratio

Current Liabilities to Net Worth Ratio measures the extent of contribution of short-term creditors and owners in the capital structure of an organization. The lower ratio infers that sufficient funds have been provided by the owners; whereas the higher ratio indicates lack of sufficiency in owners’ funds. The ratio is worked out by dividing the total current liabilities by the amount of net worth of the organization. A standard norm suggested for this ratio is 35 per cent. However, a ratio of even 30 percent or more is taken as satisfactory. The ratio of current liabilities to net worth has been worked with the help of the following formula:

Current Liabilities to Net Worth Ratio = Current Liabilities & Provisions / Net worth

3. Proprietary Ratio

Proprietary Ratio throws light on the extent of shareholders’ funds to total assets of the organization. A high proprietary ratio infers that the owners have provided funds for the organization and/or source of funds is through ploughing back of profits and the organization is less dependent on outside sources for assets. The closer is the ratio to 100 percent, the greater is the financial soundness of the company. A higher ratio suggests a sound capital structure of the company by virtue of greater margin of shareholders’ funds against outside source of finance and Margin of Safety for the creditors is greater. A low ratio, on the other hand, indicates a smaller amount of shareholders’ funds in comparison with outside borrowed funds invested in total assets. Proprietary ratio is completed with the help of the following formula :

Proprietary Ratio = Proprietors Fund / Total Assets

4. Fixed Assets to Net Worth Ratio

Fixed Assets to Net Worth Ratio highlights the extent of fixed assets financed by owners of the organization. A ratio lower than 100 infers that the net worth has exceeded the fixed assets; whereas a ratio higher than 100 means that fixed assets have exceeded net worth and part of fixed assets and all current assets are being financed by outsiders. The funds provided by owners should be adequate not only to finance entire fixed assets requirements but also to finance part of current assets. If all the funds of the owners are employed in fixed assets, the organization will have no permanent funds for financing its working capital. Thus, it can be observed that the organization’s financial position will be favorable in case the ratio is lower. The standard norm of this ratio is 65 percent for an industrial organization. However, if the nature of the organization is distributive or servicing than a lower ratio is taken as a satisfactory norm. The ratio is calculated with the help of the following formula:

Fixed Assets to Net Worth Ratio= [Fixed Assets (Net) / Net Worth] x 100

5. Fixed Assets to Long Term Debt Ratio

Fixed assets to long-term debt ratio analyses the security provided to long term liabilities. Generally, long-term borrowers give loans to organization, against the security of the fixed assets of the organization. The debenture holders have a floating charge on fixed assets of the company while other may demand mortgage of any of the fixed assets. This ratio also indicates whether additional borrowed funds may be obtained by using the same security or not. The ratio is worked out by dividing fixed assets by long-term borrowings of the company with the help of the following formula:

Fixed Assets to Long Term Debt Ratio = Fixed Assets / Long Term Debts

The greater the ratio the better will be the security of long-term debts.

6. Debt-Equity Ratio

This ratio indicates the soundness of the configuration of the Debt-Equity mix. A proper mix of debt and equity helps improving the rate of capital formation during the long period of time. Analysis of this ratio is made to see the gearing of the capital and in finding out the permanent liability of the organization in comparisons with owners’ fund.

This ratio can be found by dividing the long term debt by shareholder’s equity. This ratio is generally represented in terms of percentages. Long term debt includes all borrowings not repayable before the completion of five year period from the date of borrowings. For the purpose of calculation of this ratio the term shareholders’ equity includes share capital, reserves and surplus minus miscellaneous expenses. This ratio can be expressed thus:

Debt-Equity Ratio = Debt / Equity

The purpose of the ratio is to find out the amount of capital supplied to a business venture by the owners and also of asset “cushion” available to creditors on insolvency. To repeat, the generally accepted standard of this ratio is 1:1. Theoretically, the higher are the interests of the proprietors as compared with that of creditors, the more concrete would be the financial conditions of a business. Significantly, that ratio holds the same importance as the current ratio in the analysis of short term financial position.

7. Interest Coverage Ratio

Interest cover is nothing but profit cover of interest. In the words of Brigham. “The times-interest earned ratio is determined by dividing earnings before interest and taxes (EBIT) by the interest charges.” It is one of the most conventional coverage ratio used to test the enterprise’s debt servicing capacity. Greater the cover better is the position of the debenture holders or loan creditors regarding possibility of timely payment of interest.

The ratio indicates the extent, to which the earning may fall without causing any embarrassment to the enterprise regarding the payment of the interest charges. If the times covered falls then the risk of enterprise’s failure increase. According to Wright, “its basis as a measurement tool is that, as the times covered declines, the risk of failures increases.” A high ratio is desirable, but too high ratio indicates that the enterprise is very conservative in using debt, and it is not using credit to the best advantage of shareholders.

Interest Coverage Ratio = Interest / Profit before Interest and Tax

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