LONG-TERM FINANCIAL pOSITION
It is important for a company to be able to assess its capacity to satisfy its long-term commitments. Also, it is important and useful for a firm to quantify the sources and nature of its long-term funding and to maintain a proper balance within the components. Lending institutions, shareholders, employees, debenture holders are interested in the firm's continued ability to meet its debt repayment obligations, to operate profitably, to finance expansion, and to diversify its activities without raising additional loans. In other words, they are interested in the long-term solvency.
All the business activities of the company i.e., financing activities, operating activities, and investing activities affect the long-term solvency of the company. One of the key elements in long-term solvency is capital structure. Capital structure relates to the company's sources of financing and its economic considerations. An enterprise's risk, the possibility of losing something of value is related to capital structure and hence analysts judge the long-term solvency of an entity as part of capital structure assessment. Assessment of long-term solvency requires determining the firm's ability to generate sufficient cash flows to maintain productive capacity and meet debt and other obligations. Potential equity investors look into the financial structure and the stability of the company before they invest.
Significance of Capital Structure Ratios
The fundamental risk with a company that has debt in its capital structure is the risk of inadequacy of cash under unfavorable conditions. Debt involves a commitment to pay fixed charges (interest and principal repayments), which cannot be postponed. Also, a high debt component in the capital structure implies lessened ability to raise further debt during adverse market conditions. Capital structure ratios measure the components of capital structure and their relationship with each other or in total. A company's financial stability and solvency position depends on the financing sources and the types and sizes of various assets it owns. These ratios indicate financial strength from different points of view.
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