Capital Structure: Meaning, significance and ratios to consider while analysing a company!
A sound capital structure guarantees efficient utilisation of the available funds and ultimately helps the business in providing stakeholders with improved returns.
The capital structure of a company is primarily determined by its stage in the life cycle, its cash flow patterns and its ability to repay debt. Making sure a company has enough capital to accomplish its strategic goals and to handle any potential cash flow deficit should be the main objective of capital structure. The capital structure refers to the specific mix of equity and debt used to finance assets and functions of the company.
Three major capital components are common equity, preferred stock and debt. Equity is viewed as a more costly, long-term source of finance with better financial flexibility. In contrast, debt is less expensive but limited-to-maturity source of capital that binds a company to fulfill its cash obligations on time.
A sound capital structure also guarantees efficient utilisation of the available funds. It avoids over or under-capitalization and ultimately helps the business in providing stakeholders with improved returns. For a variety of reasons, such as lowering the total cost of capital, addressing solvency and liquidity issues, capital structure ratios help in the analysis of financial statements of any organisation.
Debt-to-equity ratio: It shows how much debt a company has compared to its assets. The ideal debt-to-equity ratio is 2:1. It indicates that the company borrows twice as much as it owns, accounting for two-thirds of its capital financing from debt and one-third from shareholder equity.
D/E ratio = Short-term debt + Long-term debt/ Total shareholders’ equity
Interest coverage ratio: It is used to assess a company's ability to pay interest on its obligations.
Interest coverage ratio = Earnings before interest and taxes (EBIT)/ Interest expense
In order to safeguard their investments, investors should always monitor these ratios in addition to evaluating the company's financial health.