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Bankruptcy is one of the natural states which a company may find itself in. Entrepreneurship is primarily about taking risks. When companies take risks, some of them succeed, whereas others fail. Hence failure is a natural part of the business. However, many critics of bankruptcy laws believe that there isn’t a need for an elaborate […]
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What is the Wirecard Scandal all about and Why it is a Wakeup Call for Whistleblowers Anyone who has been following financial and business news over the last couple of years would have heard about Wirecard, the embattled German payments firm that had to file for bankruptcy after serious and humungous frauds were uncovered leading […]
Why the Digital Age Demands Decision Makers to be Like Elite Marines and Zen Monks
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Why Indian Firms Must Strive for Strategic Autonomy in Their Geoeconomic Strategies
Geopolitics, Economics, and Geoeconomics In the evolving global trading and economic system, firms and corporates are impacted as much by the economic policies of nations as they are by the geopolitical and foreign policies. In other words, any global firm wishing to do business in the international sphere has to be cognizant of both the […]
Why Government Should Not Invest Public Money in Sports Stadiums Used by Professional Franchises
In the previous article, we have already come across some of the reasons why the government should not encourage funding of stadiums that are to be used by private franchises. We have already seen that the entire mechanism of government funding ends up being a regressive tax on the citizens of a particular city who […]
Capital structure ratios are very important to analyze the financial statements of any company for the following reasons:
Investors understand that the way a business is funded can have a lot of impact on the returns it provides.
Although the total return provided will always be the same, the way those returns are distributed amongst investors will vary.
It is for this reason that investors pay careful attention to these ratios as they help them understand the consequences of the best and worst possible scenarios.
A firm is a legal entity that has nothing when it first begins operations. It acquires capital in the form of debt and equity on different terms.
Debt has fixed returns but sure repayments. Equity on the other hand has uncertain returns but the probability of returns that far exceed those of debt-holders.
There is a cost attached to both debt and equity and the purpose of an ideal capital structure is to minimize the total cost.
The specific combination of debt and equity employed is capable of magnifying returns (both gains and losses) for equity investors. Therefore they have a special interest in ensuring that the capital structure and leverage position of the firm is in control.
An incorrect capital structure can mean ruin of an otherwise healthy firm. This is because, if the firm is funded by too much debt, it has a lot of interest bills to pay. Therefore in a lean period, the firm is likely to default on its interest obligations.
The worst part is that if the firm defaults a few times, debt holders have the right to seek legal counsel and start liquidating the firm.
In such a scenario, an otherwise healthy firm may have to sell its assets at throw away prices. Thus an ideal capital structure is one that provides enough cushions to shareholders so that they can leverage the debt-holders funds but it should also provide surety to debt holders of the return of their principal and interest.
Since capital structure ratios reveal these facts, analyst pay careful attention to them.
Capital structure ratios help investors analyze what would happen to their investments in the worst possible scenario. In case of liquidation senior debt holders have the first claim, then junior debt holders and then in the end equity holders get paid if there is anything left.
Investors can gauge what they are likely to recover if the organization went bust immediately.
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