Financial structure, capital structure (capitalization) and leverage gas vs diesel

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Firms acquire funds through debt financing, primarily from bank loans and the sale of bonds. These normally appear first on the Balance sheet as Long term liabilities. Note especially that the company’s debt (Balance sheet liabilities) also includes near term debts such as short term notes payable, accounts payable, salaries payable, and taxes payable.

These sources taken together are one full "side" of the Balance sheet. Businesspeople interested in the firm’s financial structure will compare the percentages of total funding from each source. The relative percentages define the company’s financial leverage, which determines how owners and creditors share business performance risks and rewards. Defining and Measuring Financial Leverage

One primary measure of the balance between funding sources is a leverage metric, the Total debt to equities ratio. This is sometimes called simply the Debt to equities ratio, or even more simply the Debt ratio. And, the metric is viewed as a measure of financial leverage, or Trading on equity. Note that a similar but different leverage metric, the "Long term debt to equities ratio" appears in the section below on calculating capital leverage.

Some textbooks symbolize this ratio as B / V, where B is the company’s total debt and V is company value, or total equities. And, some prefer to symbolize the same ratio as D/E, where D is total debt and E is total equities. Calculating the Total Debt to Equities Ratio (Financial Leverage)

Capital structure describes the sources of funds a company uses for acquiring income-producing assets. The focus on these funds contrasts with the financial structure concept (previous section) which includes all of the company’s debt and equities.

Those with an interest in a firm’s capital structure will compare the percentages of total funding for income-producing assets that comes from each source. They want to know, that is, whether capital funding is primarily equity funding or debt funding. Defining and Measuring Capital Leverage

One measure of the balance between capital funding sources is another leverage metric, the Long term debt to equities ratio. Obviously, this ratio is very similar to the financial leverage metric above. However, this ratio, using only long term debt, serves to measure the firm’s capital leverage. Calculating the Long Term Debt to Equities Ratio (Capital Leverage)

Note that Grande Corporation’s capital leverage (0.42) is lower than it’s financial leverage (0.68). Financial leverage will in fact always be greater than capital leverage, except in the very unlikely case that the firm has no short term debt.

Analysts also take interest in a second risk factor that accompanies high leverage, financial risk. This is the risk that a firm might not be able to meet its financial obligations. Not surprisingly, financial risk rises when the debt level rises. And, this means that financial risk increases as leverage increases.

Note that from its EBIT, a firm must first pay interest due on loans, bonds, and other debt service, before paying shareholder dividends or retaining earnings. With higher leverage, the firm simply has more debt service to pay. When earnings are low, therefore, the firm with high leverage risks being unable to meet it’s financial obligations. Not surprisingly, when a company has high financial risk, its credit ratings and bond ratings suffer. Gearing Ratios for Leverage Metrics

Analysts commonly use the term gearing ratio when working with leverage metrics. The term "gearing" is inspired by mechanical gearing, where a smaller gear wheel gains leverage (power) by turning a larger wheel. Similarly, in business, owners and their relatively smaller equity gain leverage to bring in larger earnings by using relatively more debt financing (higher gearing).

Examples in the next section show how high leverage can bring high owner returns (high earnings per share, high return on equity) if sales revenues are strong. They also show how profits and owner returns suffer in a high leverage company when sales are weak.

The numerical example in this section shows the potential impact of leverage and sales performance as they affect investor gains and losses. Exhibit 2, below, also shows how company earnings are impacted. The next section shows how to measure the risks that go with different sales and leverage figures. Example: Investor Gains and Losses as a Function of Leverage and Earnings

Management believes there is a very small but real probability that sales next year will be 0. This could result from a crippling labor strike, or a natural disaster (such as an earthquake), or the loss of several major law suits pending against the company. They also estimate 3 other levels of sales, ranging from "Low" to "High." Each column of Exhibit 2, below, shows the impacts for investors under one of following levels of sales:

What will be the impact of sales revenues on investor earnings per share and return on equity? The answer is: That depends on the financial structure of the company, especially the degree of leverage. Exhibits 2 and 3 show these impacts at four different leverage structures: