Vendor Finance in Infrastructure Projects
Debt and equity from investors remain the two conservative sources of funding when it comes to infrastructure financing. However, with the advent of time and financial innovation, newer sources of funding have now become available. Vendor financing is one such mode of funding which is now being widely used in infrastructure projects. The concept of […]
Carry Trade and Rollovers
Concept of Carry Trade Carry trade is a kind of trade that is peculiar to the Forex market. In other markets, traders trade with the intention of benefitting from capital appreciation. However, in case of carry trade, traders have two expectations. They want to earn cash from capital appreciation as well as from the interest […]
Direct Public Offerings: Threat to Investment Banking
The costs of issuing an initial public offer can be prohibitive. There are many companies across the world that want to access finances from the general public but cannot do so because they find the costs prohibitive. Hence, in order to bypass the floatation costs, these companies decide to go public without taking the help […]
Framing Bias
Traditional economic theory assumes that investors are completely rational beings. Hence, they react to information in the same way if the content of the information is the same. However, behavioral finance theory seems to disagree with this assumption. According to them, investors interpret information in different ways if it is presented to them differently. This […]
Dutch Auction
Book building has been one of the most widely used methods in the underwriting process. However, over the years, companies have realized that the book-building process is largely controlled by the intermediaries, i.e., the investment banks! The investment banks are the ones building the books. Hence, they can easily control who gets in and at […]
Capital structure ratios are very important to analyze the financial statements of any company for the following reasons:
Investors understand that the way a business is funded can have a lot of impact on the returns it provides.
Although the total return provided will always be the same, the way those returns are distributed amongst investors will vary.
It is for this reason that investors pay careful attention to these ratios as they help them understand the consequences of the best and worst possible scenarios.
A firm is a legal entity that has nothing when it first begins operations. It acquires capital in the form of debt and equity on different terms.
Debt has fixed returns but sure repayments. Equity on the other hand has uncertain returns but the probability of returns that far exceed those of debt-holders.
There is a cost attached to both debt and equity and the purpose of an ideal capital structure is to minimize the total cost.
The specific combination of debt and equity employed is capable of magnifying returns (both gains and losses) for equity investors. Therefore they have a special interest in ensuring that the capital structure and leverage position of the firm is in control.
An incorrect capital structure can mean ruin of an otherwise healthy firm. This is because, if the firm is funded by too much debt, it has a lot of interest bills to pay. Therefore in a lean period, the firm is likely to default on its interest obligations.
The worst part is that if the firm defaults a few times, debt holders have the right to seek legal counsel and start liquidating the firm.
In such a scenario, an otherwise healthy firm may have to sell its assets at throw away prices. Thus an ideal capital structure is one that provides enough cushions to shareholders so that they can leverage the debt-holders funds but it should also provide surety to debt holders of the return of their principal and interest.
Since capital structure ratios reveal these facts, analyst pay careful attention to them.
Capital structure ratios help investors analyze what would happen to their investments in the worst possible scenario. In case of liquidation senior debt holders have the first claim, then junior debt holders and then in the end equity holders get paid if there is anything left.
Investors can gauge what they are likely to recover if the organization went bust immediately.
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