Financial Ratios for Assessing Capital Structure Decisions
When analyzing financial health and growth potential of a company, one of the business owners and investors depends on the value of the Financial Ratio. And of course what you are looking for is the Financial Ratio that shows how the company’s activities are funded and how effectively the funding is used. In other words, investors want to see how the company optimally and effectively uses its capital structure.
A Brief Definition of Capital Structure
Capital structure is the allocation of debt and equity used by companies to fund operational activities and company expansion.
Equity capital is funds invested by the company owner to the company and retained earnings that represent profits from previous years. Which is where the funds are not distributed to shareholders as dividends. However, these funds are more used for debt financing or business expansion.
While debt capital is a corporate loan fund which is usually in the form of long-term bonds and other debt instruments. And the debt instrument is used to fund the company’s operational activities.
Companies tend to try to optimize their Capital Structure to achieve flexibility and healthier and stronger financial conditions. Optimizing Capital Structure means that a company must achieve certain Financial Ratio values that reflect the use of debt and equity effectively for the survival of the company.
The financial ratio that most reflects the optimization of the Capital Structure is the Debt Ratio to Equity (Debt-to-Equity Ratio) and the WACC (Weighted Average Cost of Capital). The two types of Financial Ratios proved to be very influential in reflecting the optimization of the Company’s Capital Structure based on the results of several studies related to Capital Structure.
Debt Ratio to Equity
As the name implies, Debt Ratio to Equity compares total liabilities or company debt with total financing from its equity. High Debt to Equity Ratios indicate that businesses receive a proportion of debt funding that is greater than their equity funding.
Lower Debt to Equity ratios usually indicate a more financially stable business condition. Unlike equity financing, debt must be repaid to the lender or creditor. Because debt financing also requires payment of loan principal and interest, debt can be a form of financing that is far more expensive than equity financing. Companies that use large amounts of debt may be at risk of not being able to pay off debts and borrowed interest.
Debt Ratio to Capital in the Eyes of Investors and Creditors
Creditors view companies that have high Debt to Equity Ratios will be more risky. This could be because investors don’t want to fund the company as much as funding from creditors. In other words, funds from investors do not have as much portion as creditors. The implication is that investors do not want to fund business operations because the company does not have good performance. Lack of performance may also be the reason why companies seek financing or funding more than debt instruments.
A large amount of debt usage is generally also considered a sign of risky business practices. The rule is that the source of funds for payment or repayment of debt is required regardless of the main income of the business. Companies with high Debt to Equity Ratios and financial performance declines must continue to pay their debts. Even if the business fails to generate enough revenue to cover it, it is also still mandatory to pay off its debt. Of course this can quickly cause a loan to default and end bankruptcy.
In general, lower Debt to Capital Ratios are favored by investors and creditors.
Formulation of Debt Ratio to Equity is:
Total Liabilities / Total Equity
As a simple example, PT Santuy has financial information in the form of total short-term and long-term liabilities totaling Rp120,000,000 and shareholder equity of Rp.230,000,000. Then, the value of the Debt Ratio to the Equity is 0.52.
Weighted Average Cost of Capital (WACC)
The WACC or Cost of Weighted Average Capital is the Financial Ratio that calculates the company’s funding costs for acquiring assets by comparing the debt structure and business equity. In other words, this ratio measures the true weight and cost of debt and the collection of equity funds to fund the purchase of assets and expansion of new capital based on the current level of capital structure of the company.
Management usually uses this ratio to decide whether the company must use debt or equity to finance the purchase of new assets. This ratio is fairly comprehensive because this ratio averages all sources of capital. The sources of capital include long-term debt, ordinary shares, preferred shares, and bonds. And of course this ratio is also very complex. Finding out the cost of debt may be fairly simple.
Long-term bonds and debt are issued with nominal principal and interest rates that can be used to calculate the total cost. But for equities, like ordinary shares and preferred shares, they don’t have a fixed price. And to find out the WACC value, you must calculate the equity price before applying it to the equation.
That is why many investors and creditors tend not to focus too much on this ratio. Estimating the cost of equity is based on several different assumptions that can vary from investor.
1. WACC function
Simply put, the WACC formulation helps management evaluate whether the company must finance the purchase of new assets with debt or equity by comparing the two cost options. Financing the purchase of new assets with debt or equity can make a big impact on the company’s profitability and overall stock price. Management must use the WACC equation to balance stock prices, investor return expectations, and total asset purchase costs. Executives and board of directors use the WACC to assess whether merger decisions are potentially good or bad.
On the other hand, investors and creditors use the WACC to evaluate whether a company is worth investing or given a loan. A high WACC percentage indicates the overall cost of funding a larger company and the company will have less cash to distribute to shareholders or to pay off debt. With the increase in the average cost of capital, companies tend not to create more value for investors and creditors. So that investors and creditors tend to look for investment opportunities from other companies.
2. Complexity of the Application of WACC from the Viewpoint of Financial Analysts
Assume that the company generates an average return of 15% and has an average overall capital cost of 5% every year. The company basically generates returns of 10% for every Rp1 invested or lent. An investor and creditor see that the company will only generate Rp.1.1 for every Rp1 invested. And this Rp. 0.1 value can be distributed to shareholders or used to pay off debts.
When reversed, assume that the company only produces 10% returns at the end of the year and has an average overall capital cost of 15%. This means that the company loses Rp. 0.05 from every 1 rupiah invested because the cost of capital is higher than the return. There are no investors or creditors who are interested in companies like this. Management must work to restructure funding and reduce the company’s overall capital costs.
It is not easy to use WACC as an indicator of financial analysis. Plus there are many different assumptions regarding the cost of equity. That is why many investors and capital market analysts tend to produce different WACC figures for the same company. It all depends on what the estimates and assumptions used by each investor and analyst. This is why many investors use this ratio only for speculative purposes. And they tend to use analytical tools or other financial ratios for more concrete and appropriate investment decisions.
Debt Ratio to Equity and WACC is an analysis tool that has been used by management to look for optimal Capital Structure decisions. By understanding these two ratios, at least both investors, creditors, or management can find out whether the company has used funding sources appropriately and effectively. Regarding the Financial Ratio, you can see the information from the information provided by the Financial Report.