## Capital Structure Ratios

Capital structure ratios examine the long-term solvency and financing mix of a firm — the proportion of debt and equity used to fund assets. High leverage amplifies equity returns in good times but magnifies financial risk in bad times.

### Key Building Blocks

Long-term Debt (Loan Funds): Debentures + Long-term Bank Loans + Term Loans from Financial Institutions

Equity / Net Worth / Shareholders' Funds / Proprietors' Funds:

= Equity Share Capital + Preference Share Capital + Reserves & Surplus − Miscellaneous Expenditure − Accumulated Losses

Capital Employed / Total Funds / Investment:

Liability Route: Debt + Equity
Asset Route: Net Fixed Assets + Net Working Capital

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### 1. Debt to Total Assets Ratio

Formula: = Long-term Debt / Total Assets

### 2. Debt Ratio

Formula: = Total Debt (Short + Long term) / Net Assets

### 3. Equity to Total Funds Ratio

Formula: = Equity / Capital Employed

Ideal: ~33% — at least one-third of long-term funds should be owners' equity.

### 4. Debt-Equity Ratio ★ (Most Tested)

Formula: = Long-term Debt / Equity (or Total Debt / Equity)

Ideal: 2:1 — up to ₹2 of debt per ₹1 of equity is considered acceptable by Indian financial institutions.
Higher ratio → greater financial risk and dependence on borrowed funds.

### 5. Capital Gearing Ratio

Formula: = (Preference Capital + Debentures + Other Borrowed Funds) / Equity Shareholders' Funds

Numerator = ALL fixed-charge capital (preference capital + all debt)
Denominator = Equity Shareholders' Funds only = Equity Share Capital + Reserves − Misc. Expenditure (Preference capital is excluded from denominator)
High gearing = amplified returns for equity holders in good times; high risk in bad times.

### 6. Proprietary Ratio

Formula: = Proprietary Funds (Net Worth) / Total Assets

Shows what proportion of total assets is financed by owners — the complement of the overall debt ratio.

### 7. Fixed Assets to Long-Term Funds Ratio

Formula: = Net Fixed Assets / Long-Term Funds

Ideal: < 1 — long-term funds should at minimum cover all fixed assets.
Ratio > 1 → short-term funds are financing fixed assets (aggressive / risky approach).

### Financing Approaches

Approach	Fixed Assets to LT Funds	Working Capital Funding
Conservative	< 1	LT funds fund part of WC
Matching	= 1	LT funds exactly cover fixed assets
Aggressive	> 1	Short-term funds fund fixed assets

Worked example

### Example 1

Example 1 – FLOW Ltd.: Capital Structure Ratios (from Question 8)

Balance Sheet data (₹ in lakhs):

Equity Shares (₹10 each) = 3.50; 10% Preference Shares = 2.00; Reserves & Surplus = 2.00
Long-term Loan (12%) = 1.00; Debentures (14%) = 2.50
Net Fixed Assets = 7.50 + Goodwill (1.40) = 8.90; Total Assets = 12.65

Long-term Debt = 1.00 + 2.50 = ₹3.50 lakhs

Equity (Net Worth) = 3.50 + 2.00 + 2.00 = ₹7.50 lakhs

Capital Employed = 3.50 + 7.50 = ₹11.00 lakhs

Debt-Equity Ratio = 3.50 / 7.50 = 0.47:1 (very conservative; well below the 2:1 norm)

Capital Gearing Ratio = (Preference + Debentures + LT Loan) / Equity Share Funds

= (2.00 + 2.50 + 1.00) / (3.50 + 2.00) = 5.50 / 5.50 = 1:1

(Note: Preference capital of 2.00 goes into the numerator, not the denominator)

Proprietary Ratio = 7.50 / 12.65 = 0.59 (59% of assets funded by owners — strong)

Fixed Assets to LT Funds = Net Fixed Assets / LT Funds = 8.90 / 11.00 = 0.81 (< 1, conservative ✓)

### Example 2

Example 2 – VRA Limited: Reconstructing P&L from Capital Structure Data (from Question 13)

Given: Debt-Equity Ratio = 2:1; 14% Long-term Debt = ₹5,00,000; Capital Turnover = 1.2; GP Ratio = 30%; Return on Equity = 50%; Tax Rate = 35%; Opening Stock = ₹4,50,000; Closing Stock = 8% of Sales

Step 1 – Equity and Capital Employed

D/E = 2:1 → Equity = Debt / 2 = 5,00,000 / 2 = ₹2,50,000

Capital Employed = 5,00,000 + 2,50,000 = ₹7,50,000

Step 2 – Sales and COGS

Sales = Capital Turnover × CE = 1.2 × 7,50,000 = ₹9,00,000

COGS = 70% × 9,00,000 = ₹6,30,000

Closing Stock = 8% × 9,00,000 = ₹72,000

Purchases = COGS + Closing Stock − Opening Stock = 6,30,000 + 72,000 − 4,50,000 = ₹2,52,000

Step 3 – Net Profit and EBIT

EAT = Return on Equity × Equity = 50% × 2,50,000 = ₹1,25,000

EBT = 1,25,000 / (1 − 0.35) = ₹1,92,308

Interest = 14% × 5,00,000 = ₹70,000

EBIT = 1,92,308 + 70,000 = ₹2,62,308

Operating Expenses = GP − EBIT = 2,70,000 − 2,62,308 = ₹7,692

⚠️ Common exam mistakes

Including Preference Share Capital in Equity Shareholders' Funds when computing Capital Gearing Ratio — preference capital belongs in the numerator (fixed-charge capital), not the denominator.
Using total debt (including current liabilities like creditors and overdraft) when only long-term debt is required for the Debt-Equity Ratio.
Forgetting to deduct Miscellaneous Expenditure and Accumulated Losses from Equity (Net Worth) — these reduce the owners' claim.
Confusing Proprietary Ratio (Net Worth / Total Assets) with Equity to Total Funds Ratio (Net Worth / Capital Employed) — the denominators differ.
Misclassifying Fixed Assets to LT Funds > 1 as 'good' — a ratio above 1 signals that short-term funds are financing fixed assets, which is aggressive and risky.

Reference:

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