Page 93 - DMGT409Basic Financial Management

Basic Financial Management

Notes z Capital structure refers to the mix of long-term sources of funds, such as equity shares
capital, reserves and surpluses, debenture, long-term debt from outside sources, and
preference share capital.
z Capital structure is indicated by the equation: Capital structure = Long-term debt +
Preferred stock + Net worth or Capital structure = Total assets – Current liabilities.
z Leverage has been defined as, the action of a lever and mathematical advantage gained by

it. From the fi nancial management point of view, the term leverage is commonly used to
describe the firm's ability to use fixed cost assets or sources of funds to magnify the returns

to its owners.
z There are two types of leverages: (i) operating leverage and (ii) fi nancial leverage.
z Operating leverage (OL) refers as the firm's ability to use operating costs to magnify the

effects of changes in sales on its earnings before interest and taxes.
z Financial leverage (FL) is the ability of the firm to use fi xed financial charges to magnify the

effects of changes in EBIT on the firm's earnings per share.
5.6 Keywords

Capital Structure: It is that part of financial structure, which represents long-term sources.

Financial Leverage: Financial leverage (FL) is the ability of the firm to use fi xed fi nancial charges

to magnify the effects of changes in EBIT on the firm’s earnings per share.

Operating Leverage: Operating leverage may be defined as the firm’s ability to use operating

costs to magnify the effects of changes in sales on its earnings before interest and taxes.
5.7 Self Assessment

Fill in the blanks:
1. Capital structure is that part of ........................, which represents long-term sources.
2. The term capital structure refers to the mix of ........................ sources of funds.
3. ........................ is possible only when there is a mix of debt and equity.

4. From the financial management point of view, ........................ is commonly used to describe

the firm’s ability to use fixed cost assets or sources of funds to magnify the returns to its
owners.
5. ........................ is associated with investment (assets acquisition) activities.

6. Operating leverage may be defined as the firm’s ability to use ........................ to magnify the
effects of changes in sales on its earnings before interest and taxes.
7. ........................ results from the presence of fi xed financial charges in the income statement.

8. Financial leverage associates with ........................ .
9. The issue of debt depends on the future ........................ of the company.
10. Small companies and companies with low credit ratings must rely more on ........................
market
State whether the following statements are true or false:
11. Company issues preference shares or redeemable debentures when it requires fi nance.
12. Trading on equity uses the variable cost sources of finance in capital structure of fi rm.

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