Financial Management & Cost Accounting

Module 4. Financial Statement analysis

Lesson 20
CAPITAL STRUCTURE RATIO

20.1 Introduction

The capital structure ratio shows the percent of long term financing represented by long term debt.A capital structure ratio over 50% indicates that a company may be near their borrowing limit (often 65%). The capital structure ratio is included in the financial statement ratio analysis spreadsheets highlighted in the left column, which provide formulas, definitions, calculation, charts and explanations of each ratio.

20.2 Meaning of Capital Structure

A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.

Formula to calculate capital structure ratio

Capital Structure Ratio = Long term debt / (Shareholders equity + Long term debt).

Debt to Equity Ratio = Total Liabilities/ Total Stockholder's Equity

Interest Coverage Ratio = Income Before Interest and Income Tax Expenses / Interest Expense

Income Before Interest and Income Tax Expenses

= Income before Income Taxes + Interest Expense

Profit Margin = Net Income / Sales

Assets Turnover Ratio = Sales / Averages Total Assets

The external users of Financial Statements primarily include the investors, creditors or short term and long term lenders. A potential investor is basically interested in his returns in the form of cash dividend as well as the capital gain that he can realize from eventually selling the stock. These returns depend upon how profitable is the company currently and how profitable it will be in future. Therefore, a potential shareholder is interested in the relationships within the company that indicate the present and future profitability of the enterprise and how such profitability could be translated into cash dividend.

Often, both the size and type of organization will dictate the kind of accounting methods used. Financial statement analysis is used to identify the trends and relationships between financial statement items. Both internal management and external users (such as analysts, creditors, and investors) of the financial statements need to evaluate a company's profitability, liquidity, and solvency. The most common methods used for financial statement analysis are trend analysis, common-size statements, and ratio analysis. These methods include calculations and comparisons of the results to historical company data, competitors, or industry averages to determine the relative strength and performance of the company being analyzed.