Leverage and Capital Structure

Leverage and Capital Structure

* Leverage and capital structure analysis illustrates the entity's use of debt and its ability to service this debt as it occurs.

* The introduction of debt into an entity's capital structure introduces an element of financial risk however the returns in excess of the cost of the debt will be captured by shareholders. Therefore the investment is seen to be "leveraged" or "geared". There are also a number of tax benefits to financing ventures with debt.

* There is therefore no "ideal" level of debt in a business.

* The below 2 tables indicate the extent to which Cochlear and Ramsey have been financed using debt over the past 5 years.

* It can be seen that 5 years ago, both entities had a similar use of debt, with liabilities being approximately 2/3rds of assets

* In the past 5 years, Cochlear have consistently reduced their reliance on debt. The amount of actual debt has remained relatively consistent however the percentage of debt compared with Assets and equity has reduced each year to the point where there is now more owners' equity than debt.

* Ramsey on the other hand has increased its reliance on debt over the past 5 years. Whilst total assets and total shareholders' equity has increased over the 5 year period, the proportion of debt compared to assets and equity has increased. This proportion peaked in 2009, with debt being 2.5 times owners' equity.

* Weakness - The ratios above have been calculated using total liabilities and totals assets. Not all liabilities are debt and the usage of these ratios is a matter of convenience. A more thorough ratio could be calculated by using data relating to interest bearing debt only. This would require eliminating balances due to trade creditors and provisions as deferred tax liabilities.

* The general interpretive rule is that higher debt to assets and debt to equity ratios are signs of greater financial risk. A rule of thumb would indicate that the debt to equity ratio of Cochlear which is less than 1:1 indicates a robust capital structure however Ramsey's 2:1 ratio indicates a weakness.

* What is more relevant than a rule of thumb however is to investigate the amount and volatility of business cash flows compared to cash outflows required by the debt burden. Those entities with strong, steady and predictable cash flows will be in a position to use large amounts of debt relative to equity. That is, the capacity of an entity to service its debt. We therefore look at Times interest earned...

* It can be clearly shown that