Capital Structure

Capital structure refers to how an organisation gets the money to fund its assets. As we know from the Balance Sheet, assets are either funded by equity or by liabilities. Equity financing allows owners to decide for themselves if they want to draw their contributions out, however liabilities require repayment and interest. If an organisation is using too much debt to finance its operation, it is running the risk of being unable to pay the interest or the debt itself.

A Capital structure ratio will answer the following question: Will our lenders take the chance of lending us more money?

The main capital structure ratio that we will discuss is called the debt ratio.

Debt Ratio

A company's ability to survive over the long term, which is related to its debt position, is measured by these ratios. The debt position of a firm indicates the amount of non-owner or non-self-generated funds used by the business. In general, the more debt a firm uses, the higher the risk. Due to the influence of financial leverage, debt could actually increase the return to owners but at the risk of possible insolvency should the company not be able to service its debt.

Debt is part and parcel of the way modern companies are financed. As long as the margin of safety provided by own funds is sufficient and the company is able to meet its debt related obligations there is no reason why debt could not be used. The only proviso is that the company must earn more with the borrowed funds than the cost thereof, that is positive financial leverage.

Debt ratio = Total liabilities x 100 (Total assets)

How to interpret this ratio: Assets can be sold off for cash and are therefore an indication that the organisation can pay back its liabilities. The smaller the percentage, the smaller the risk, as it means that fewer assets are being financed by debt.

Debt Ratio

= total liabilities ÷ total assets

= R10 000 000 + R10 700 000 ÷ R31 000 000

= 0.668 or 66.8%

Industry norm 47.7%

For each rand invested in assets, R0.66 was financed by debt. Put differently, only R0.34 of each rand invested in assets belongs to the owners.

Times Interest Earned (TIE)

= Earnings before interest and tax ÷ Interest paid

= R4 000 000 ÷ R1 000 000

= 4 times

Interest is covered more than the 2.4 times of the industry norm. Note that when TIE equals 1, net income before tax is zero. Although Jimco's debt ratio seems to be on the high side, interest payments should easily be met, as indicated by the TIE ratio.

Note that these two ratios should always be judged together. A company can have a fairly low (good) debt ratio and a very low (bad) TIE ratio and vice versa.

Click here to view an explanation about Debt Ratio.