Capital structure ratios are also known as leverage ratios. Capital structure ratios may be defined as those financial ratios which measure the long term stability and structure of the firm. These ratios indicate the mix of funds provided by the owners and lenders and assure the lenders of the long term fund with respect to:
a. Periodic payment of interest during the period of the loan and
b. Repayment of principal amount on maturity.
Hence, leverage ratios are of two kinds:
i. Capital structure ratios and
ii. Coverage ratios
Capital structure ratios
These ratios provide an insight into the financing techniques used by the business and focus on the long term solvency position. From the balance sheet one can get only the absolute funds employed and its sources, but they do not convey any significant message about their proportion to another type of source of funds. For example: Debt ratio, it is used to know how much debt is there in total capital employed.
There are three main types of capital structure ratios:
Equity Ratio: It indicates proportion of owners’ funds to the total funds invested in the business. Old school of law believed that more equity is safe for the firm and there should be more weight of equity in the total capital.
Formula of Equity Ratio = Shareholders’ Equity / Total Capital Employed
Debt Ratio: It is computed as Total debt/ Capital employed.
Here, total debt includes short term as well as long term debt, borrowings from the financial institutions, bonds, debentures, bank borrowings. In short, it includes every type of external funding apart from equity.
Deb to Equity Ratio = It is computed as
Debt+Preferred Long Term/ Shareholders’ Equity
Here, preferred stock capital is also added to debt because we are making comparison with respect to equity shareholders. Preference share is non-debt security but they get preference like creditors while repayment of capital. Hence, it assumed as external capital.