Page 2 - Lesson Note 4

Generally companies use the concept of financial leverage to set up capital

structure.

Financial Leverage /Trading on equity

Financial leverage refers to proportion of debt in the overall capital:

Financial leverage = D/E Where D= Debt, E= Equity.

With debt fund companies funds and earnings increases because debt is a
cheaper source of finance but it is very risky to involve more debt in capital

structure. More debt will result increase in earning only where rate of earnings of
the company ,i.e. return on investment should be more than rate of interest is
more than the earnings or ROI of the company then more debt means loss for

the company.

Factors determining the capital structure.

1. Cash flow position.

The decision related to composition of capital structure also depends upon
the ability to business to generate enough cash flow.

The company is under legal obligation to pay fixed rate of interest to
debenture holders, dividend to preference shares and principal and interest

amount for loan.
Sometimes company makes sufficient profit but it is not able to generate

cash inflow for making payments.
The expected cash flow must watch the obligation of making payment
because if company fails to make fixed payment it may face insolvency.

Before including the debt in capital structure company must analyze
properly the liquidity of its working capital.

2. Interest coverage ratio (ICR):
It refers to number of time companies earnings before interest and taxes

(EBIT) cover the interest payment obligation.
High ICR means companies can have more of borrowed fund securities

where as lower ICR means less borrowed fund securities.
3. Debt service coverage Ratio(DSCR):