Capital structure Ratios are also known as Capital Gearing Ratio or solvency ratios or leverage ratios. These are used to analyse the long term solvency of any particular business concern. There are two aspects of long term solvency of a firm:
(i) Ability to repay the principal amount when due, arid
payment of interest. In other words long term creditors like debenture holders, financial institution etc. are interested in the security of their loan amount as well as the ability of the company to meet.
The company to know whether it will be able to pay off interest on loan amount. Liquidity ratios discussed earlier indicate short term-financial strength whereas solvency ratios judge the ability of a firm to pay off its long term liabilities. Important solvency ratios are discussed below:
Important Capital Structure Ratios
1. Debt equity ratio.
2. Proprietary ratio.
3. Interest coverage ratio.
4. Debt to total funds ratio.
5. Capital gearing ratio
Debt Equity Ratio
This ratio tries to measure the connection between shareholders’ funds and long term debts. In other words, this particular ratio measures the comparable claims of long term creditors on the one hand and owners on the other hand, about the assets of the organization.
Significance and objective
Proprietary ratio exhibits the extent to which investors own the business and so indicates the general financial durability of the business. The greater the proprietary ratio, the higher the long term stability of the organization and consequently higher protection to creditors. However, an extremely high proprietary ratio might not necessarily be great because if funds of outsiders are not employed for long term financing, a company may riot be capable of take advantage of investing on equity.
This ratio is very important from lenders point of view because it indicates the ability of a company to pay interest out of its profits. This ratio also indicates the extent to which the profits of the company may decrease without in any way affecting its ability to meet its interest obligations.
The standard for this ¡ratio for an industrial company is that interest charges should be covered six to seven times.
This ratio shows the proportion of funds supplied by outsiders in the total funds employed in the business. The rower this ratio, the better it is for creditors because they are more secure and vice-versa, higher this ratio it gives a feeling of insecurity to the creditors. In other words, a high ratio of debts to total funds employed is a danger signal for creditors. This ratio also serves the purpose of indicating the possibility of raising additional loans.
Capital Gearing Ratio
This is actually the ratio among the fixed interest bearing securities and equity share capital. Fixed revenue securities contain debentures and preference share capital. A company is highly geared if this ratio is more than one. If it is less than one, it is low geared. If the ratio is exactly one, it is evenly geared. A highly geared company has the advantage of trading on equity and called as capital gearing ratio.