Debt and equity as means of raising finance:

We will take a look at one particular borrower: the business firm. We shall see how firms take decisions about raising finance for their short-term and long-term requirements. Firms can raise finance either by borrowing (debt) or by issuing shares. So when we are talking of shares, we have only the primary market in mind. We are looking from a firm's point of view and asking how much of the finance should be raised by incurring debt, and how much should be raised through issue of shares. Is there some theory or some principles that will help the firm to make a decision? This is what we discuss now. A firm has several assets that it invests in, and these investments generate a stream of cash flows.  If the firm is entirely equity financed, these cash flows belong only to the shareholders. On the other hand, the firm can offer shares but also go in for borrowings. This will offer the lenders some risk-free investment opportunity. How much of the capital the firm should raise through debt and how much  through equity is a decision that is important for the firm. This is called the capital structure of the firm. To understand the decision regarding capital structure of the firm, we will first look at some indicators of the firm's financial position, particularly some financial ratios. One can look at the balance sheet and the income statements. Balance sheets look at the situation with assets and liabilities at a particular point of time while the income statement is a view of the earnings and expenditure that takes place over a specified period of time, usually a year. We can also look at a firm's generation of cash. But what we propose to do now is to look at some important financial ratios regarding a firm's financial activity and performances. Ratio analysis forms a powerful tool in assessing the financial condition of the firm and enables us to relate disparate financial data with each other. Ratio analysis of this sort will enable us to understand the capital structure of the business firm.

Different people and groups have varying stakes in the firm and they will have different concerns over a firm's performance.  Stockholders and bondholders will be concerned about the long-term profitability of the firm, while creditors will look to see  whether the firm is able to meet its payments on time. The management of the firm is concerned with both the long run and short  run as well as day-to-day performance. There are several types of ratios that we shall be considering now. All of these can be  grouped into four types: liquidity ratios, which measure the ability and adequacy of the current assets to meet current liabilities as they come due; activity ratios, which give an indication of the efficiency with which the firm uses its resources;  financial leverage ratios, which measure how effective the firm is in managing its debt; and finally, profitability ratios, which measure how effective the firm is in generating net revenues and income in relation to sales, costs, assets and shareholder equity.