Capital structure indicators

Capital structure indicators – to measure the stability of the company

Capital structure indicators show the riskiness of a business. As funding is often determined for years by the sources from which it operates, the role of these indicators is highlighted.

Notations in the calculation of capital structure ratios

Fixed assets

Assets, that serving the business for more than 1 year.

Accounts receivable

A claim for payment legally arising from contracts. This has already been fulfilled by the contractor and accepted and acknowledged by the other party.

Accounts payable

Recognized debt arising from the performance of a contract or legislation.

Long-term liabilities

Liabilities with a maturity of more than 1 year. This does not include the part of these items within one year.

Short-term liabilities

The original payment liabilities within 1 year and the part of long-term liabilities within one year.

Equity

Resource made available to owners by the owners without time limit.

How much do you know about the ratios?

The capital structure

The capital structure of a company shows the composition of the funds at its disposal.

“Making money requires money, but not necessarily yours.”
– Kiyosaki

The same is true for businesses. They also need money for production, but it is not necessarily to rely solely and exclusively on the capital provided by the owners.

Resources can be both own resources and external sources.
You will find your own funds as the capital subscribed in your books as well as as a result of the previous year’s balance sheet.
You will find the obligations as a liability in your accounting books. Liabilities can take many forms:

credit
loan
bond issued

Why is it important to know the capital structure?

Firms operating in the same industry are copying each other under the influence of a kind of herd spirit, and as a result, their funding and results will be similar.
Not only the result achieved, but also the risk they take (even if not consciously) will be common.
If you monitor your own capital structure and thus make an informed decision, you will also have an impact on your achievable results.

What you need to know about the capital structure.

Different capital items may have different costs.
In most cases, it is suggested that don’t use external sources, but achieve everything with your own resources. Because owners ’return expectations are generally higher than creditors’ return expectations due to higher risk-bearing, lending can even reduce costs.

A business can obtain a long-term liability either through a bond issue or a bank loan. For this to happen, it must show stable operations and development plans that also win the trust of creditors. Thus, a higher value indicates significant improvements but an aggressive financing policy.
However, the very high value also carries risks due to the high loan portfolio. Capital structure indicators also help to monitor this.

Is there an ideal composition?

The ideal capital structure has been addressed by many (such as the Modigliani-Miller theorem), but it is no accident that several, even contradictory, views have emerged. This is because there is no one-size-fits-all optimal capital structure for a given company.

What is definitely true, however, is that it will be different for different sources

cost of capital
the risk involved
the amount of income that can be generated with the given capital
the time distribution of the income that can be produced

In the case of a company, an analysis could be made for practically all balance sheet lines, so now only the most frequently used (ie most important) capital structure indicators follow.

Capital structure indicators focusing on the equity ratio

Capital adequacy ratio

Equity Ratio = Equity / Total Assets

It shows the degree of credit risk and stability. The higher its value, the lower the proportion of external sources, so the risk to the business is less.
Although every company is different, in general, a value below 30% is already critical.

One of the most frequently studied capital structure indicators is

Liabilities / Equity ratio (D / E)

D / E = Liabilities / Equity

It is advantageous if the value of the indicator is between 1.5-1.8, but a value above 2 can also be normal.

Leverage

Leverage = Balance sheet total / Equity

Leverage shows how many units of assets a firm operates with 1 unit of equity. Its value is always 1 or above. The value of the indicator is exactly 1 if the company is financed 100% from equity. If the company already has credit, the value of the ratio will be higher than 1, so this capital structure ratio is even called a capital multiplier.

Capital structure indicators expressing the degree of indebtedness

Indebtedness ratio

Debt ratio = (Long-term loans and borrowings + short-term loans and borrowings + Overdrafts) / Equity

In short, the indebtedness ratio:

Debt ratio = Liabilities / Equity

It shows the proportion of the business financed by creditors and the proportion of owners. For a manufacturing company with a high demand for fixed assets, a lower value is desirable, while for a trading company, a higher value is acceptable due to the fast turnover rate (you can usually buy goods from an overdraft to finance inventories).

Long – term debt ratio

Long-term debt ratio = Long-term liabilities / (Long-term liabilities + equity)

It shows the proportion of the business that is financed by the owners and the proportion by the creditors.
In the case of an investment or loan, the longer term also carries more risk. Thus, having a higher ratio of long-term liabilities to a firm is tantamount to making the firm riskier.
Although its value may vary depending on capital requirements and industry, it can be said to be critical if it shows a value above 60%. It is then advisable to reduce the loan portfolio.

Stability index

Stability ratio = (Equity + Long – term liabilities) / Fixed assets

It is advisable to finance long-term assets with long-term resources. The indicator shows how much this has been achieved. A value above 1 is desirable.

Net debt ratio

Net debt ratio = (Liabilities – Receivables) / Equity

It is not an extraordinary event in the life of a company to cover its liabilities from the amount received from the liabilities (eg when its customers pay).
The net debt / equity ratio shows the extent to which equity is covered by liabilities that are not (yet) payable.
If you look on your own, the lowest value is desirable, and if you look at a trend over time, the downward trend is the goal.
This indicator assumes that the amount from receivables flows earlier than the liabilities should be paid.

Questions:

Which indicator do you use to monitor stability?
At what intervals do you look at how the trend in capital structure indicators is evolving?
How do you align stability as a long-term goal with your short-term goals?

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