Capital Structure or Leverage Ratios | Formulae
Table of Contents
Capital Structure or Leverage Ratio
Capital structure refers to the degree of long term financing of a business concern as in the form of debentures, preference share capital and equity share capital including reserves and surplus. There should be a proper mix between debt capital and equity capital. Capital structure is otherwise called as leverage.
Formulae to Calculate Capital Structure or Leverage Ratios
Capital structure ratios are calculated to test the long term financial position of the business concern. The followings ratios are calculated to analyze the capital structure of the business concern.
1. Capital Gearing Ratio
- Financial Leverage
- Operating Leverage
- Combined Leverage.
2. Debt Equity Ratio.
3. Total Investment to Long Term Liabilities
4. Ratio of Fixed Assets to Funded Debt.
5. Ratio of Current Liabilities to Proprietors’ Funds.
6. Ratio of Reserves to Equity Capital.
Capital Gearing Ratio
This ratio shows the relationship prevailing between equity share capital including reserves and surplus and preference share capital along with fixed interest bearing loans for long term. If equity share capital including reserves and surplus is less when compared with preference share capital and fixed interest bearing loans for long term, there is a high gearing and vice versa. The followings formulae are used to calculate Capital Gearing Ratio.
Capital Gearing Ratio = (Equity Share Capital + Reserves and Surplus) / (Preference Share Capital+ Fixed Interest bearing loans)
or
Capital Gearing Ratio = Fixed Income bearing Funds / Equity Shareholders’ Fund
or
Capital Gearing Ratio = Fixed Income bearing Funds / Total Capital Employed
Leverage may be classified as financial leverage, operating leverage and combined leverage.
Financial Leverage or Trading on Equity
Financial leverage is the using of equity share capital and preference share capital along with long term fixed interest bearing debt. The company can use long term fixed interest bearing debt very effectively. If so, the earnings of more than fixed interest is available only to the equity shareholders. In this way, the returns to equity share holders is increased. It means that the earnings of equity shareholders is increased by effective use of long term fixed interest bearing debt. It is known as trading on equity.
Financial leverage can be calculated as
Financial leverage = Earnings Before Interest and Tax / (Earnings Before Interest and Tax — Interest and Preference Dividend)
Operating leverage can be calculated as
Operating leverage = (Sales — Variable Cost) / Earnings Before Interest and Tax
Combined leverage can be calculated as
Combined leverage = Financial Leverage x Operating Leverage
Total Investment to Long Term Liabilities
This ratio is calculated by the following formula.
= (Shareholders’ Funds+ Long Term Liabilities) / Long Term Liabilities
High ratio is preferable.
Ratio of Fixed Assets to Funded Debt
This ratio is calculated by the following formula.
= Fixed Assets / Funded Debt
Ratio of Current Liabilities to Proprietors’ Funds
This ratio is calculated by the following formula.
= Current Liabilities / Proprietors’ Funds
Ratio of Reserves to Equity Capital
This ratio indicates the level of profits retained within the business as reserve for future growth. This ratio is calculated by the following formula.
= Reserves / Equity Share Capital x 100
High ratio is preferable.
Miscellaneous Ratios
The different types of ratios are analysed under various headings. Even though, some other ratios are also developed by experts and analysts. Such types of ratios are presented below.
Finance Expense Ratio = Financial Expenses / Net Sales x 100
Rate of Dividend = Dividends / Paidup Capital x 100
Ratio of Disposable Profit to Paid up Capital = Disposable Profit / Paid up Capital x 100
Rate of Ploughing Back of Profits or Rate of Retention = Rate of Dividend — Ratio of Disposable Profit to paid up Capital
Dividend Cover Ratio = Profit After Interest and Tax / Dividend
Dividend cover ratio reveals the ability of the business concern to maintain the dividend in future.
Current Assets Turnover Ratio = Cost of Sales or Net Sales / Current Assets
Owned Capital Turnover Ratio = Cost of Sales or Net Sales / Shareholders’ Fund
Ratio of Tangible Assets to Total Debts = Tangible Assets / Total Debt
Here, Tangible Assets = Total Assets — Intangible assets
