Spoilage and Rework in Job Order Costing System
What Is Rework? Rework is that part of the final produce which has not been accepted by the client because it does not meet the required specifications. However, those specifications can be met by working on the item once again. Hence the name rework. What Is Spoilage? Spoilage is also that part of the final […]
The Case for Index Funds
People who invest their money in stocks can be split up into two categories. One category of people actively decide which stock they want to invest their money in. This means that these investors spend their time and money doing research on individual stocks. On the other hand, the other category of people invests their […]
What is Investment Banking?
The topic of investment banking is fascinating. This is because some of the biggest banks in the world i.e., Barclays, JP Morgan, Citi, Morgan Stanley, etc. all have investment banking divisions. In fact, they have had investment banking divisions for a very long time. The average age of these investment banks is often said to […]
An Overview of Contracts and Why They are Important to Business and Society
Contracts govern all transactions whether they are between firms or between firms and private individuals. Indeed, in most of the developed world, any transaction or commercial exchange is usually not undertaken without a contract. This trend is also catching up in the developing world where contracts are increasingly becoming the norm. The importance of contracts […]
What are Profit Margins ?
The untrained investor uses profit and profit margin interchangeably. This is not technically correct. The difference may be minor but it is vital. This article will explain about profit margins in detail. Profit vs. Profit Margins Profit and profitability are two different things. Although they may be closely related, they have a subtle difference. Profit […]
Capital structure ratios are very important to analyze the financial statements of any company for the following reasons:
Investors understand that the way a business is funded can have a lot of impact on the returns it provides.
Although the total return provided will always be the same, the way those returns are distributed amongst investors will vary.
It is for this reason that investors pay careful attention to these ratios as they help them understand the consequences of the best and worst possible scenarios.
A firm is a legal entity that has nothing when it first begins operations. It acquires capital in the form of debt and equity on different terms.
Debt has fixed returns but sure repayments. Equity on the other hand has uncertain returns but the probability of returns that far exceed those of debt-holders.
There is a cost attached to both debt and equity and the purpose of an ideal capital structure is to minimize the total cost.
The specific combination of debt and equity employed is capable of magnifying returns (both gains and losses) for equity investors. Therefore they have a special interest in ensuring that the capital structure and leverage position of the firm is in control.
An incorrect capital structure can mean ruin of an otherwise healthy firm. This is because, if the firm is funded by too much debt, it has a lot of interest bills to pay. Therefore in a lean period, the firm is likely to default on its interest obligations.
The worst part is that if the firm defaults a few times, debt holders have the right to seek legal counsel and start liquidating the firm.
In such a scenario, an otherwise healthy firm may have to sell its assets at throw away prices. Thus an ideal capital structure is one that provides enough cushions to shareholders so that they can leverage the debt-holders funds but it should also provide surety to debt holders of the return of their principal and interest.
Since capital structure ratios reveal these facts, analyst pay careful attention to them.
Capital structure ratios help investors analyze what would happen to their investments in the worst possible scenario. In case of liquidation senior debt holders have the first claim, then junior debt holders and then in the end equity holders get paid if there is anything left.
Investors can gauge what they are likely to recover if the organization went bust immediately.
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