The capital structure of a business is the mix of types of debt and equity the company has on its balance sheet. The capital of a business can be evaluated by knowing how much of the ownership is in debt and how much in equity. The company's debt might include both short-term debt and long-term debt and equity, including common stock, preferred shares, and retained earnings. Capital structure concept is extremely important because it can influence not only the return a company earns for its shareholders, but whether or not a firm survives in a recession or depression.
Interest cover measures net income against total interest payments. Debt accrues an interest charge, which the company has to finance. The interest cover ratio effectively measures a company's ability to service its debt. What shareholders don't want is for operating profits to be dissipated by a large interest bill. Theoretically, net income should cover interestat least one times, but that would mean all net income earned is used to ser\'ice debts- leaving no profit available for reinvestment into the business. Companies with an interest cover ratio of less than one times should definitely be avoided. If they can't pay interest it means they'll have to skimp on other crucial expenditure - and paying dividends isn't apriority (or possibility) at all. (ANDRÉ JANSE VAN VUUREN 25 Mar,2010 p.58)
Capitalization ratios, also widely known as financial leverage ratios, provide a glimpse of a company's long term stability and ability to withstand losses and business downturns. By comparing debt to total capitalization, these ratios reflect the extent to which a corporation is trading on its equity, and the degree to which it finances operations with debt.
Financial leverage ratios present analysts and investors with an excellent picture of a company's situation, how much financial risk it has taken on, its dependence on debt, and developing trends. Knowing who controls a company's capital tells one who truly controls the enterprise.
A business finances its assets with either equity or debt. Financing with debt involves risk, since debt legally obligates a company to pay off the debt, plus the interest the debt incurs. Equity financing, on the other hand, does not obligate the company to pay anything. It pays investors dividends-but this is at the discretion of the board of directors. To be sure, business risk accompanies the operation of any enterprise. But how that enterprise opts to finance its operations-how it blends debt with equity-may heighten this risk.
• Capitalization ratio need to be evaluated over time, and compared with other data and standards.
• Capitalization ratio should be interpreted in the context of a company's earnings and cash flow, and those of its competitors.
