Accounting Business Reporting for Decision Making

CHAPTER 8 Analysis and interpretation of financial statements 343

8.7 Capital structure analysis

LEARNING OBJECTIVE 8.7 Define, calculate and interpret the ratios that measure capital structure.

An entity’s capital structure is the proportion of debt financing relative to equity financing, and reflects the

entity’s financing decision. As per the accounting equation, an entity’s assets equal its liabilities plus equity.

Investments in assets are funded externally by liabilities, or internally by owner’s equity. Expressing any of

these three items — assets, liabilities and equity — relative to each other will reveal how an entity has used

debt relative to equity to finance assets. Capital structure ratios (also referred to as gearing ratios) depict the

proportion of debt to equity funding, and are useful when assessing an entity’s long-term viability. Achieving

a balance between debt and equity funding affects the entity’s ROE. The use of debt can be advantageous, as

debt funding is cheaper than equity funding. The lower cost of debt reflects:

• the lower returns required by debt holders, given the lower risk borne by debt holders relative to

equity holders

• the tax deductibility of interest expense.

However, excessive debt levels can be burdensome for an entity if the cost of servicing the debt

exceeds the return generated by investments in assets (i.e. the cost of debt exceeds the return on assets),

and this will depress the return on equity. If the debt is being used profitably, and the return on assets

financed with debt exceeds the cost of borrowing, then the benefit accrues to the owners in the form of

higher returns on equity.

Capital structure ratios

The ratios that reflect an entity’s use of debt relative to equity to finance assets are as follows.

Debt to equity ratio:

Total liabilities

× 100 = x%

Total equity

Debt ratio:

Total liabilities

×100 = x%

Total assets

Equity ratio:

Total equity

×100 = x%

Total assets

It is necessary to calculate only one of the above three capital structure ratios, as they all indicate the

entity’s use of debt relative to equity to finance its investments in assets. We will focus on the debt ratio,

which indicates how many dollars of liabilities exist per dollar of assets. If this exceeds 50 per cent, then

the entity finances its investments in assets by relying more on debt relative to equity. If the debt ratio is

less than 50 per cent, then the entity finances more of its assets with equity than with debt. The debt to

equity ratio indicates how many dollars of debt exist per dollar of equity financing. If this ratio exceeds

100 per cent, then the entity is more reliant on debt funding than equity funding. The equity ratio sug-

gests the dollars of equity per dollar of assets. If this ratio is less than 50 per cent, then the entity is more

reliant on debt funding than equity funding.

Illustrative example 8.2 shows these ratios for an entity with $100 million of assets, $70 million of debt

and $30 million of equity on its balance sheet. The entity is more reliant on debt relative to equity, as indi-

cated by the ratios. The debt ratio indicates that the entity uses $2.33 of debt per dollar of equity. Other ways

of expressing this are: the debt ratio tells us that the entity funds every $1 of assets with $0.70 of debt; and

the equity ratio indicates that every $1 of assets is financed by $0.30 of equity. The debt ratio divided by the

equity ratio gives the debt/equity ratio, and the sum of the debt ratio and equity ratio equals 100 per cent.