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The capital structure is how a firm finances its overall operations and growth by using different sources
of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as
common stock, preferred stock or retained earnings. Short-term debt such as working capital
requirements is also considered to be part of the capital structure.
BREAKING DOWN 'Capital Structure'
A firm's capital structure can be a mixture of long-term debt, short-term debt, common equity and
preferred equity. A company's proportion of short- and long-term debt is considered when analyzing
capital structure. When analysts refer to capital structure, they are most likely referring to a firm's debt-
to-equity (D/E) ratio, which provides insight into how risky a company is. Usually, a company that is
heavily financed by debt has a more aggressive capital structure and therefore poses greater risk to
investors. This risk, however, may be the primary source of the firm's growth.
Debt vs. Equity
Debt is one of the two main ways companies can raise capital in the capital markets. Companies like to
issue debt because of the tax advantages. Interest payments are tax-deductible. Debt also allows a
company or business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt
is abundant and easy to access.
Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity
does not need to be paid back if earnings decline. On the other hand, equity represents a claim on the
future earnings of the company as a part owner.
Debt-to-Equity Ratio as a Measure of Capital Structure
Both debt and equity can be found on the balance sheet. The assets listed on the balance sheet are
purchased with this debt and equity. Companies that use more debt than equity to finance assets have
a high leverage ratio and an aggressive capital structure. A company that pays for assets with more
equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage
ratio and/or an aggressive capital structure can also lead to higher growth rates, whereas a
conservative capital structure can lead to lower growth rates. It is the goal of company management to
find the optimal mix of debt and equity, also referred to as the optimal capital structure.
Analysts use the D/E ratio to compare capital structure. It is calculated by dividing debt by equity. Savvy
companies have learned to incorporate both debt and equity into their corporate strategies. At times,
however, companies may rely too heavily on external funding, and debt in particular. Investors can
monitor a firm's capital structure by tracking the D/E ratio and comparing it against the company's
peers.
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insight into how risky a company is for potential investors. Determining an optimal capital structure is
a chief requirement of any firm's corporate finance department.
Companies can raise capital with either debt or equity. Each strategy has its own advantages and
disadvantages. Debt usually costs less than equity due to tax advantages, especially when rates are low.
However, debt also obligates the company to pay out a portion of future earnings, even when earnings
are declining. By contrast, equity does not need to be paid back; however, equity comes with an
exchange of ownership. Most companies use a mix of both debt and equity to raise capital. This mix is
referred to as the capital structure. It is the goal of most public companies to operate at an optimal
capital structure to maximize profits.
Optimal Capital Structure
There are two ways to think about optimal capital structure. One is personal and one is business-
related. A chief executive officer (CEO) may not like debt in her personal life; however, her company
may require the use of debt to maximize profits. At some point the debt becomes a strain on earnings.
Qualitatively, the optimal capital structure lies somewhere between maximum profitability and
financial burden.
Quantifying Optimal Capital Structure
The most popular way analysts measure capital structure is with the debt-to-equity ratio. Some analysts
compare it against other companies in the same industry. The assumption is these companies are
operating at an optimal capital structure, which is a significant assumption. In this case, an analyst can
select a few of the best-performing or high-growth companies in the industry for comparison. The
assumption holds but is less significant.
Another way to determine optimal debt-to-equity levels is to think like a bank. What is the optimal level
of debt a bank is willing to lend? An analyst may also utilize other debt ratios to put the company into a
credit profile using a bond rating. The default spread attached to the bond rating can then be used for
the spread above the risk-free rate of a AAA-rated company.
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Total Debt to Capitalization = ($5 million + $25 million) / ($5 million + $25 million + $50 million) =
0.375 or 37.5%
The acceptable level of capitalization ratios for a company depends on the industry in which it operates.
Companies in sectors such as utilities, pipelines and telecommunications which are capital intensive
and have predictable cash flows will typically have capitalization ratios on the higher side. Conversely,
companies with relatively few assets that can be pledged as collateral in sectors like technology and
retail will have lower levels of debt and therefore lower capitalization ratios.
The acceptable level of debt for a company is dependent on its whether its cash flows are adequate to
service such debt. The interest coverage ratio, another popular leverage ratio, measures the ratio of a
companys earnings before interest and taxes (EBIT) to its interest expense. A ratio of 2, for instance,
indicates the company generates $2 for every dollar in interest expense.
As with all ratios, a companys capitalization ratios should be tracked over time to identify if they are
stable. They should also be compared with similar ratios of peer companies, to ascertain the companys
leverage position relative to its peers.
What is 'Gearing'
Gearing refers to the level of a companys debt related to its equity capital, usually expressed in
percentage form. It is a measure of a companys financial leverage and shows the extent to which its
operations are funded by lenders versus shareholders. The term "gearing" also refers to the ratio
between a companys stock price and the price of its warrants.
BREAKING DOWN 'Gearing'
Gearing can be measured by a number of ratios, including the debt-to-equity ratio, equity ratio and debt-
service ratio. The ratios serve as indicators regarding the level of risk associated with a particular
business. The appropriate level of gearing for a company depends on its sector, as well as the degree of
leverage employed by its peers. For example, a gearing ratio of 70% shows that a companys debt levels
are 70% of its equity. A gearing ratio of 70% may be very manageable for a utility, as the business
functions as a monopoly with support through local government channels, but it may be far too much
for a technology company with high levels of competition in a rapidly changing marketplace.
Use of Gearing Ratios:
Lenders may consider a businesss gearing ratio when determining whether to extend credit. This
information can be combined with whether or not the loan will be supported with collateral, as well as
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if the lender will qualify as a senior lender should the business fail. With this in mind, senior lenders
may choose to remove short-term debt obligations when calculating the gearing ratio, as senior lenders
receive priority in case of the businesss bankruptcy.
In cases in which a lender would be offering an unsecured loan, the gearing ratio may include
information regarding the presence of senior lenders as well as preferred stock holders that have
certain payment guarantees. This allows the lender to adjust the calculation to reflect the higher level
of risk than would be present with a senior lender.
Gearing Ratio and Risk
In general, a company with excessive leverage, as demonstrated by its high gearing ratio, may be more
vulnerable to economic downturns. This is because it has to make interest payments and service its
debt through cash flows that may be significantly lower due to the downturn. The flip side of this
argument is that leverage works well during good times, since all the excess cash flows accrue to
shareholders once the debt service payments have been made.
In contrast, lower leverage does not guarantee sound financial management on the part of the business.
Certain industries that are highly cyclical in nature, such as those with significant seasonal variances,
may not have the funds available year-round to meet debt obligations over a specific amount. This could
include businesses in certain agricultural sectors as well as those tied to fluctuating seasonal demands,
such as garden centers
What is 'Leverage'
Leverage is the use of various financial instruments or borrowed capital, such as margin, to increase the
potential return of an investment.
2. The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is
considered to be highly leveraged.
Leverage is most commonly used in real estate transactions through the use of mortgages to purchase
a home.
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Meaning of Financial Management
Financial Management means planning, organizing, directing and controlling the financial activities
such as procurement and utilization of funds of the enterprise. It means applying general management
principles to financial resources of the enterprise.
Scope/Elements
Investment decisions includes investment in fixed assets (called as capital budgeting).
Investment in current assets are also a part of investment decisions called as working capital
decisions.
Financial decisions - They relate to the raising of finance from various resources which will
depend upon decision on type of source, period of financing, cost of financing and the returns
thereby.
Dividend decision - The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two:
Dividend for shareholders- Dividend and the rate of it has to be decided.
Retained profits- Amount of retained profits has to be finalized which will depend upon
expansion and diversification plans of the enterprise.
Objectives of Financial Management
The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-
To ensure regular and adequate supply of funds to the concern.
To ensure adequate returns to the shareholders which will depend upon the earning capacity,
market price of the share, expectations of the shareholders.
To ensure optimum funds utilization. Once the funds are procured, they should be utilized in
maximum possible way at least cost.
To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate
rate of return can be achieved.
To plan a sound capital structure-There should be sound and fair composition of capital so that
a balance is maintained between debt and equity capital.
Functions of Financial Management
1. Estimation of capital requirements: A finance manager has to make estimation with regards
to capital requirements of the company. This will depend upon expected costs and profits and
future programmes and policies of a concern. Estimations have to be made in an adequate
manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity analysis. This
will depend upon the proportion of equity capital a company is possessing and additional funds
which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many choices
like-
o Issue of shares and debentures
o Loans to be taken from banks and financial institutions
o Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period of
financing.
4. Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
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o Disposal of surplus: The net profits decision have to be made by the finance manager. This
can be done in two ways:
o Dividend declaration - It includes identifying the rate of dividends and other benefits like
bonus.
5. Retained profits - The volume has to be decided which will depend upon expansional,
innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries, payment
of electricity and water bills, payment to creditors, meeting current liabilities, maintainance of
enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the funds but
he also has to exercise control over finances. This can be done through many techniques like
ratio analysis, financial forecasting, cost and profit control, etc.
The trading on equity concept is more likely to be employed by professional managers who do not own
a business, since the managers are interested in increasing the value of their stock options with this
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aggressive financing technique. A family-run business is more interested in long-term financial stability,
and so is more likely to avoid the concept.
Example of Trading on Equity
Able Company uses $1,000,000 of its own cash to buy a factory, which generates $150,000 of annual
profits. The company is not using financial leverage at all, since it incurred no debt to buy the factory.
Baker Company uses $100,000 of its own cash and a loan of $900,000 to buy a similar factory, which
also generates a $150,000 annual profit. Baker is using financial leverage to generate a profit of
$150,000 on a cash investment of $100,000, which is a 150% return on its investment.
Baker's new factory has a bad year, and generates a loss of $300,000, which is triple the amount of its
original investment.
Similar Terms
Trading on equity is also known as financial leverage, investment leverage, and operating leverage.
Gearing Ratio
The gearing ratio measures the proportion of a company's borrowed funds to its equity. The ratio
indicates the financial risk to which a business is subjected, since excessive debt can lead to financial
difficulties. A high gearing ratio represents a high proportion of debt to equity, and a low gearing ratio
represents a low proportion of debt to equity. This ratio is similar to the debt to equity ratio, except that
there are a number of variations on the gearing ratio formula that can yield slightly different results.
A high gearing ratio is indicative of a great deal of leverage, where a company is using debt to pay for
its continuing operations. In a business downturn, such companies may have trouble meeting their debt
repayment schedules, and could risk bankruptcy. The situation is especially dangerous when a company
has engaged in debt arrangements with variable interest rates, where a sudden increase in rates could
cause serious interest payment problems.
A high gearing ratio is less of a concern in a regulated industry, such as a utility, where a business is in
a monopoly situation and its regulators are likely to approve rate increases that will guarantee its
continued survival.
Lenders are particularly concerned about the gearing ratio, since an excessively high gearing ratio will
put their loans at risk of not being repaid. Possible requirements by lenders to counteract this problem
are the use of restrictive covenants that prohibit the payment of dividends, force excess cash flow into
debt repayment, restrictions on alternative uses of cash, and a requirement for investors to put more
equity into the company. Creditors have a similar concern, but are usually unable to impose changes on
the behavior of the company.
Those industries with large and ongoing fixed asset requirements typically have high gearing ratios.
A low gearing ratio may be indicative of conservative financial management, but may also mean that a
company is located in a highly cyclical industry, and so cannot afford to become overextended in the
face of an inevitable downturn in sales and profits.
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How to Calculate the Gearing Ratio
The most comprehensive form of gearing ratio is one where all forms of debt - long term, short term,
and even overdrafts - are divided by shareholders' equity. The calculation is:
Long-term debt + Short-term debt + Bank overdrafts/Shareholders' equity
Another form of gearing ratio is the times interest earned ratio, which is calculated as shown below,
and is intended to provide some indication of whether a company can generate enough profits to pay
for its ongoing interest payments.
Earnings before interest and taxes/Interest payable
Another variation on the gearing ratio is the long-term debt to equity ratio; it is not especially useful
when a company has a large amount of short-term debt (which is especially common when no lenders
are willing to commit to a long-term lending arrangement). However, it can be of use when the bulk of
a company's debt is tied up in long-term bonds.
Gearing Ratio Example
In Year 1, ABC International has $5,000,000 of debt and $2,500,000 of shareholders' equity, which is a
very high 200% gearing ratio. In Year 2, ABC sells more stock in a public offering, resulting in a much
higher equity base of $10,000,000. The debt level remains the same in Year 2. This translates into a 50%
gearing ratio in Year 2.
How to Reduce Gearing
There are a number of methods available for reducing a company's gearing ratio, including:
Sell shares. The board of directors could authorize the sale of shares in the company, which
could be used to pay down debt.
Convert loans. Negotiate with lenders to swap existing debt for shares in the company.
Reduce working capital. Increase the speed of accounts receivable collections, reduce
inventory levels, and/or lengthen the days required to pay accounts payable, any of which
produces cash that can be used to pay down debt.
Increase profits. Use any methods available to increase profits, which should generate more
cash with which to pay down debt.
Similar Terms
Gearing is also known as leverage.
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Financial Planning - Definition, Objectives and Importance
Definition of Financial Planning
Financial Planning is the process of estimating the capital required and determining its competition. It
is the process of framing financial policies in relation to procurement, investment and administration
of funds of an enterprise.
Objectives of Financial Planning
Financial Planning has got many objectives to look forward to:
Determining capital requirements- This will depend upon factors like cost of current and fixed
assets, promotional expenses and long- range planning. Capital requirements have to be looked
with both aspects: short- term and long- term requirements.
Determining capital structure- The capital structure is the composition of capital, i.e., the relative
kind and proportion of capital required in the business. This includes decisions of debt- equity
ratio- both short-term and long- term.
Framing financial policies with regards to cash control, lending, borrowings, etc.
A finance manager ensures that the scarce financial resources are maximally utilized in the best
possible manner at least cost in order to get maximum returns on investment.
Importance of Financial Planning
Financial Planning is process of framing objectives, policies, procedures, programmes and budgets
regarding the financial activities of a concern. This ensures effective and adequate financial and
investment policies. The importance can be outlined as-
Adequate funds have to be ensured.
Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds
so that stability is maintained.
Financial Planning ensures that the suppliers of funds are easily investing in companies which
exercise financial planning.
Financial Planning helps in making growth and expansion programmes which helps in long-run
survival of the company.
Financial Planning reduces uncertainties with regards to changing market trends which can be
faced easily through enough funds.
Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the
company. This helps in ensuring stability an d profitability in concern.
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examining preliminary financial statements for inaccuracies, to see if adjustments should be made
before the statements are released for general use.
Investment analysis. An investor can create a trend line of historical share prices, and use this
information to predict future changes in the price of a stock. The trend line can be associated with other
information for which a cause-and-effect relationship may exist, to see if the causal relationship can be
used as a predictor of future stock prices. Trend analysis can also be used for the entire stock market,
to detect signs of a impending change from a bull to a bear market, or the reverse.
When used internally (the revenue and cost analysis function), trend analysis is one of the most useful
management tools available. The following are examples of this type of usage:
Examine revenue patterns to see if sales are declining for certain products, customers, or sales
regions.
Examine expense report claims for evidence of fraudulent claims.
Examine expense line items to see if there are any unusual expenditures in a reporting period
that require additional investigation.
Extend revenue and expense line items into the future for budgeting purposes, to estimate future
results.
When trend analysis is being used to predict the future, keep in mind that the factors formerly impacting
a data point may no longer be doing so to the same extent. This means that an extrapolation of a
historical time series will not necessarily yield a valid prediction of the future. Thus, a considerable
amount of additional research should accompany trend analysis when using it to make predictions.
'Cash Flow'
Cash flow is the net amount of cash and cash-equivalents moving into and out of a business.
Positive cash flow indicates: That a company's liquid assets are increasing, enabling it to settle debts,
reinvest in its business, return money to shareholders, pay expenses and provide a buffer against future
financial challenges.
Negative cash flow indicates: that a company's liquid assets are decreasing. Net cash flow is
distinguished from net income, which includes accounts receivable and other items for which payment
has not actually been received. Cash flow is used to assess the quality of a company's income, that is,
how liquid it is, which can indicate whether the company is positioned to remain solvent.
BREAKING DOWN 'Cash Flow'
The accrual accounting method allows companies to count their chickens before they hatch, so to speak,
by considering credit as part of a company's income. "Accounts receivable" and "settlement due from
customers" can appear as line items in the assets portion of a company's balance sheet, but these items
do not represent completed transactions, for which payment has been received. They do not, therefore,
count as cash. (Note that the credit vs. cash distinction is not the same as it is in everyday terminology;
proceeds from credit card transactions are considered cash once they are transferred.)
The opposite can also be true. A company may be receiving massive inflows of cash, but only because it
is selling off its long-term assets. A company that is selling itself for parts may be building up liquidity,
but it is limiting its potential for growth in the long term, and perhaps setting itself up to fail. In the same
vein, a company may be taking in cash by issuing bonds and taking on unsustainable levels of debt. For
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these reasons it is necessary to view a company's cash flow statement, balance sheet and income
statement together.
Cash Flow Statement
Often called the "statement of cash flows," the cash flow statement indicates whether a company's
income is languishing in the form of IOUs not a sustainable situation in the long term or is translating
into cash flow. Even very profitable companies, as measured by their net incomes, can become insolvent
if they do not have the cash and cash-equivalents to settle short-term liabilities. If a company's profit is
tied up in accounts receivable, prepaid expenses and inventory, it may not have the liquidity to survive
a downturn in its business or a lawsuit. Cash flow determines the quality of a company's income; if net
cash flow is less than net income, that could be a cause for concern.
Cash flow statements are divided into three categories: operating cash flow, investing cash flow
and financing cash flow.
Operating cash flows are those related to a company's operations, that is, its day-to-day business.
Investing cash flows relate to its investments in businesses through acquisition; in long-term assets,
such as towers for a telecom provider; and in securities.
Financing cash flows relate to a company's investors and creditors: dividends paid to stockholders
would be recorded here, as would cash proceeds from issuing bonds.
Free cash flow is defined as a company's operating cash flow minus capital expenditures. This is the
money that can be used to pay dividends, buy back stock, pay off debt and expand the business.
Cash flow
Cash flow is the net amount of cash that an entity receives and disburses during a period of time. A
positive level of cash flow must be maintained for an entity to remain in business.
The time period over which cash flow is tracked is usually a standard accounting reporting period, such
as a month, quarter, or year. Cash inflows come from the following sources:
Operations. This is cash paid by customers for services or goods provided by the entity.
Financing activities. An example is debt incurred by the entity.
Investment activities. An example is the gain on invested funds.
Cash outflows originate with the following sources:
Operations. This is expenditures made as part of the ordinary course of operations, such
as payroll, the cost of goods sold, rent, and utilities.
Financing activities. Examples are interest and principal payments made by the entity, or the
repurchase of company stock, or the issuance of dividends.
Investment activities. Examples are payments made into investment vehicles, loans made to
other entities, or the purchase of fixed assets.
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An alternative way to calculate the cash flow of an entity is to add back all non-cash expenses (such as
depreciation and amortization) to its net after-tax profit, though this approach only approximates
actual cash flows.
Cash flow is not the same as the profit or loss recorded by a company under the accrual method of
accounting, since accruals for revenues and expenses, as well as for the delayed recognition of cash
already received, can cause differences from cash flow.
A persistent, ongoing negative cash flow based on operational cash flows should be a cause of serious
concern to the business owner, since it means that the business will require an additional infusion of
funds to avoid bankruptcy.
A summary of the cash flows of an entity is formalized within the statement of cash flows, which is a
required part of the financial statements under both the GAAP and IFRS accounting frameworks.
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There are two ways in which to present the statement of cash flows, which are the direct method and
the indirect method. The direct method requires you to present cash flow information that is directly
associated with the items triggering cash flows, such as:
Cash collected from customers
Interest and dividends received
Cash paid to employees
Cash paid to suppliers
Interest paid
Income taxes paid
Few organization collect information as required for the direct method, so they instead use the indirect
method. Under the indirect approach, the statement begins with the net income or loss reported on the
company's income statement, and then makes a series of adjustments to this figure to arrive at the
amount of net cash provided by operating activities. The following links provide more information
about the direct method and indirect method.
Direct method
Indirect method
Similar Terms
The statement of cash flows is also known as the cash flow statement.
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'Fund Flow'
Fund flow is the net of all cash inflows and outflows in and out of various financial assets. Fund flow is
usually measured on a monthly or quarterly basis; the performance of an asset or fund is not taken into
account, only share redemptions, or outflows, and share purchases, or inflows. Net inflows create excess
cash for managers to invest, which theoretically creates demand for securities such as stocks and bonds.
BREAKING DOWN 'Fund Flow'
Investors and market analysts watch fund flows to gauge investor sentiment within specific asset
classes, sectors or the market as a whole. For instance, if net fund flows for bond funds during a given
month are negative by a large amount, this signals broad-based pessimism over the fixed-income
markets.
A fund flow focuses on the movement of cash only, reflecting the net movement after examining inflows
and outflows of monetary funds. These movements can include payments to investors or payments
made to the company in exchange for goods and services.
The fund flow does not include any funds due to be paid but have not yet been paid. This includes
arrangements where a debtor is scheduled to pay a certain amount per a completed contract, but the
payment has not been received and the obligations on the part of the company have not been settled.
Fund Flow Statements
A fund flow statement is a disclosure of the types of inflows and outflows the company has experienced.
It is a forum in which to provide information regarding any fund flow activity that might be out of the
ordinary, such as a higher-than-expected outflow due to an irregular expense. Further, it often
categorizes the various transaction types and sources to help track any activity changes.
Fund Flow Changes
If the fund flow changes, it often reflects a change in customer sentiment. This can be related to new
product releases or improvements, recent news regarding the company or shifts in feelings on the
industry as a whole. Positive fund flow changes note an upswing in inflow, a lessening of outflow or a
combination of the two. In contrast, negative fund flow suggests lower inflows, higher outflows or both.
While occasional shifts may not be indicative of issues within the company, prolonged negative fund
flows can be a sign there are some issues present, as this is a reflection of income not being sufficient to
meet the companys expenses. If this trend continues, it could mean the company needs to acquire a
form of debt to continue operations.
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Cash flow refers to the current format for reporting the inflows and outflows of cash, while funds flow
refers to an outmoded format for reporting a subset of the same information.
Cash flow is derived from the statement of cash flows. This statement is required under Generally
Accepted Accounting Principles (GAAP), and shows the inflows and outflows of cash generated by a
business during a reporting period. The information in a statement of cash flows is aggregated into the
following three areas:
Operating activities. Comprised of the main revenue-generating activities of a business, such as
receipts from the sale of goods and payments to suppliers and employees.
Investing activities. Involves the acquisition and disposal of long-term assets, such as cash
received from the sale of property.
Financing activities. Involves changes in cash from selling or paying off financing instruments,
such as from the issuance or repayment of debt.
The statement of cash flows is part of the main group of financial statements that a business issues,
though it is commonly considered to be third in importance after the income statement and balance
sheet. The statement can be of considerable use in detecting movements of cash that are not readily
apparent by perusing the income statement. For example, the income statement may reveal that a
business earned a large profit, while the statement of cash flows shows that the same business actually
lost cash while doing so (probably due to large investments in fixed assets or working capital). Thus,
cash flow analysis is useful for determining the underlying health of a business.
The funds flow statement was required under GAAP from the period 1971 through 1987. The statement
primarily reported changes in an entity's net working capital position between the beginning and end
of an accounting period. Net working capital is an entity's current assets minus its current liabilities
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