Analysis of the Funding Structure
In this lesson, you’re expected to learn about:
– funding structure ratios
– gearing and the shareholders’ perspective
We have seen how to calculate the return on this capital in the previous lesson. What we are interested in now is the way the funding is made up, i.e. what proportion of the funding comes from different sources.
Net Debt = £4,672k
Shareholders’ Equity = £2,847k
The debt to total funding ratio is thus the debt divided by the total funding, i.e. it shows what percentage of total funding is debt:
Debt to Total Funding = Debt / Total Funding
= 4,672 / 7,519
The debt to total funding ratio shows you at a glance how much of a business is funded by debt and, by deduction, how much by equity.
However, many people prefer to summarize the funding structure in a slightly different way. They divide the debt by the equity and express it as a percentage. This ratio, known as the debt to equity ratio shows how large the debt is relative to the equity.
Debt to Equity Ratio = Debt / Equity
Debt to Equity Ratio = 4,672 / 2,847
This tells us that the company’s debt is 1.64 times bigger than its equity.
The debt to equity ratio is probably the more common of the two ratios.
We know that gearing is another word for the debt to equity ratio.
It is also used more generally to describe the concept of borrowing money to make an investment. In the US, the word ‘leverage’ is used to mean the same thing.
Gearing affects the risk of and potential returns to shareholders. Therefore, shareholders ought to control the level of debt a company takes on but in practice, management tends to decide.
If a company’s debt to tax funding ratio continues to rise over a period of a few years, the shareholders’ risk has risen considerably.
Shareholders are ultimately interested in the return on the money they have invested i.e. the return on equity – known as ROE.
Since we know a company’s equity, the return is the profit after paying the interest on the loans, i.e. profit before tax.
Return on Equity = Profit before tax / Equity
For private companies, you can get a rough estimate from the accounts by taking the interest paid during the year and dividing it by the average debt at the start and end of the year.
Average Interest Rate = Interest / Average Debt
Although ROE measures the return to shareholders for having invested their money in a company over the last year, they do not actually get all this return out of the company in the form of cash.
Remember that profit is not cash. The company is probably still waiting to collect cash from debtors and has manufactured more stock for next year. Some of the profit, however, is paid out in the form of dividends.
One measure of this is dividend cover which is calculated as profit for the year divided by the dividend.
Dividend Cover = Profit for the year / Dividend for the year
This is simply the inverse of dividend cover expressed as a percentage. It shows what percentage of the profit for the year is paid out as dividends:
Payout Ratio = Dividend / Profit for the year
A company’s financial objective is to maximize the return it provides on the money invested, based on an appropriate trade-off between the short- and long-term perspectives, while ensuring that the business remains liquid.
Analyzing a company’s liquidity is quite difficult and there is no single KPI that tells you very much. However, there are two ratios which are commonly used as measures of liquidity which we will cover briefly:
– Current Ratio
– Quick Ratio
The logic behind this is that the current assets should be convertible into cash within one year and the current liabilities are what you have to pay within one year.
Provided your current assets are greater than your current liabilities, you should not have a liquidity problem.
Current Ratio = Current Assets / Current Liabilities
How do you assess liquidity?
Ideally, you make week-by-week or month-by-month forecasts of exactly what bills are going to have to be paid when and what customers are going to pay when.
Other than the annual report, it is recommended to look at the cash flow statement for this purpose.