Accounting Business Reporting for Decision Making

344 Accounting: Business Reporting for Decision Making

ILLUSTRATIVE EXAMPLE 8.2

Capital structure ratios measuring the use of debt relative

to equity funding

Assets = Liabilities + Equity

$100 m = $70 m + $30 m

Capital structure ratios

Debt/equity ratio = 70/30 = 233%

Debt ratio = 70/100 = 70%

Equity ratio = 30/100 = 30%

Debt ratio + equity ratio = 100%

What is the appropriate level of debt funding relative to equity funding? Debt funding increases an

entity’s financial risk and the variability of cash flows to equity holders. The ability of an entity to absorb

financial risk depends on the variability of its cash flows, which in turn is influenced by the entity’s busi-

ness risk. An entity that operates in a seasonal or risky industry will experience greater variability in its

cash flows from operations, and therefore have less ability to assume large financial risk. It is common to

find variations in capital structure ratios across industries, but entities within an industry tend to operate

at similar gearing levels.

An arbitrary benchmark that is used for a debt ratio is 50 per cent — an entity should use equal por-

tions of debt and equity to finance its assets. This is not to say that a ratio exceeding 50 per cent proves

that the entity’s long-term financial viability is jeopardised. Many mature entities have debt ratios larger

than 50 per cent.

When looking at how an entity has financed assets, the extent of current borrowings should also be

examined. An entity that relies on current borrowings needs to refinance on a regular basis, and may face

the situation when the current debt is due of the financing not being available or only being available at a

higher cost. For example, the global financial crisis made it more difficult for entities to access debt, and

entities with short-term debt maturing had difficulty refinancing.

Capital structure ratios (as well as interest coverage ratios) are often used in lending contracts as a

means of protecting the lender’s wealth. For example, a loan contract could include a covenant specifying

that the entity’s debt ratio must not exceed 70 per cent. If the entity breaches this covenant by allowing

its debt to assets to exceed 70 per cent, the lender has the right to withdraw the loan facility and demand

that the entity repay the loan. This illustrates how accounting numbers are used in entities’ contrac-

tual arrangements. Users should focus on the trend in the ratio as an increasing reliance on debt over a

number of years would be of concern. When analysing an entity’s capital structure, it is also relevant to

examine the type of interest-bearing debt the entity is using, the breakdown of the debt into short and

long term, and the maturity structure of the long-term debt.

Interest servicing ratios

The financial risk of the entity can also be assessed using the interest coverage ratio (also referred to as

times interest earned). This ratio measures the number of times an entity’s EBIT covers the entity’s net

finance costs. It indicates the level of comfort that an entity has in meeting interest commitments from

earnings. The calculation is:

EBIT

=x times

Net finance costs