Capital Structure or Leverage Ratios | Formulae

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.

Ratio Analysis - Capital Structure or Leverage Ratio

Image: Ratio Analysis – Capital Structure or Leverage Ratio

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

  1. Financial Leverage
  2. Operating Leverage
  3. 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

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