Capital Structure Ratios - Meaning and Importance

Capital structure ratios are very important to analyze the financial statements of any company for the following reasons:

  • Same Business Can Yield Different Returns

    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.

  • Combination That Reduces Total Cost of Capital

    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.

  • Nature of Capital Employed Can Magnify Returns

    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.

  • Solvency of the Firm

    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.

  • Liquidation of the Firm

    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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