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Leverage/Capital Structure Ratios

The second category of financial ratios is leverage or capital structure ratios. The long-term lenders/creditors would judge the soundness of a firm on the basis of the long-term financial strength measured in terms of its ability to pay the interest regularly as well as repay the installment of the principal on due dates or in one lump sum at the time of maturity. The long-term solvency of a firm can be examined by using leverage or capital structure ratios. The leverage or capital structure ratios may be defined as financial ratios which throw light on the long-term solvency of a firm as reflected in its ability to assure the long-term lenders with regard to (j) periodic payment of interest during the period of the loan and (ii) repayment of principal on maturity or in predetermined installments at due dates.

There are, thus, two aspects of the long-term solvency of a firm: (i) ability to repay the principal when due, and (ii) regular payment of the interest. Accordingly, there are two different, but mutually dependent and interrelated, types of leverage ratios. First, ratios which are based on the relationship between borrowed funds and owner’s capital. These ratios are computed from the balance sheet and have many variations such as (a) debt-equity ratio, (b) debt-assets ratio, (c) equity-assets ratio, and so on, The second type of capital structure ratios, popularly called coverage ratios, are calculated from the profit and loss account. Included in this category are (a) interest coverage ratio. (b) dividend coverage ratio, (c) total fixed charges coverage ratio, (d) cash flow coverage ratio, and (e) debt services coverage ratio.

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