FINC3600 Chap.3 Capital Structure, Leverage and Liquidity
Capital Structure, Leverage and Liquidity
Capital structure analysis explains how a company funds its assets and how much flexibility remains for a new strategic commitment. Net debt, gearing, leverage, liquidity headroom, maturity concentration, and covenant capacity answer different questions and must not be treated as interchangeable.
The analyst should reconcile gross debt, cash, and lease treatment before calculating any ratio, then test how the proposed action changes both numerator and denominator. A static ratio is only the starting point. Decision-quality analysis connects the current position to funding amount, timing, refinancing exposure, downside cash flow, and management's tolerance for reduced flexibility.
What this chapter covers
- 01
Gross debt, cash and net debt reconciliation
- 02
Gearing as a capital mix measure
- 03
Net debt to EBITDA leverage
- 04
Liquidity headroom and committed facilities
- 05
Debt maturities and refinancing concentration
- 06
Lease treatment and definition consistency
- 07
Pro forma funding capacity
Worked example · free
Reconcile capital structure and test a funded investment
- +1Calculate current net debt as $450 million less $90 million, giving $360 million.
- +1Calculate gearing as $360 million divided by $360 million plus $840 million, giving 30.0%.
- +1Calculate leverage as $360 million divided by $200 million, giving 1.8 times.
- +1Assuming cash and EBITDA are initially unchanged, pro forma net debt becomes $480 million and leverage becomes 2.4 times.
- +1Pro forma gearing becomes $480 million divided by $480 million plus $840 million, or about 36.4%.
- +1Conclude that debt capacity is reduced and test maturity timing, liquidity headroom, covenants, downside EBITDA, and eventual investment cash flows before recommending.
Key terms
- Gross Debt
- Interest-bearing borrowings before deducting cash or cash equivalents.
- Net Debt
- Gross debt less cash and eligible cash equivalents under the stated definition.
- Gearing
- Net debt divided by net debt plus equity, used here as a capital mix measure.
- Leverage
- Net debt divided by EBITDA, indicating debt relative to an earnings capacity proxy.
- Liquidity Headroom
- Available cash and committed undrawn facilities after expected near-term uses.
- Maturity Wall
- A concentration of debt repayments or refinancing needs within a short period.
- Pro Forma
- A recalculated financial position showing the assumed effect of a proposed transaction.
Capital Structure, Leverage and Liquidity FAQ
Why are gearing and leverage both needed?
Gearing describes the balance between net debt and equity, while leverage compares net debt with an earnings proxy. A company can look moderate on one measure and stretched on the other because market values, accumulated equity, or cyclical EBITDA differ. Use both, then examine liquidity, maturities, and downside resilience.
Should lease liabilities be included in net debt?
The answer depends on the analytical purpose and the comparison boundary. Include or exclude leases consistently across the company, peers, leverage inputs, and any covenant comparison. State the treatment explicitly and, when the conclusion is sensitive, show a bridge between reported borrowings and the chosen analytical net-debt measure.
Does unused borrowing capacity prove an investment is affordable?
No. A facility can provide immediate liquidity while still increasing leverage, interest exposure, covenant pressure, or refinancing concentration. Affordability requires a pro forma view of cash needs, debt maturities, downside EBITDA, committed facilities, and the timing of project benefits. Capacity is conditional, not simply the amount a lender will advance.
How should a downside case be presented?
Change a small number of material drivers, such as EBITDA, cash conversion, funding cost, or project timing, and show the resulting leverage and liquidity headroom. Explain why each stress is plausible and identify the threshold that would force a funding change, delay, or mitigation. Avoid an unexplained table of arbitrary percentages.
Assessment move
Memorise the sequence rather than isolated formulas: reconcile gross debt and cash, state lease treatment, calculate net debt, calculate gearing and leverage, map maturities, and test liquidity headroom. Work several short numerical cases by hand and narrate what each answer means. Then convert one case into a pro forma analysis by adding a transaction, changing EBITDA, and considering the funding date.
Always add a sentence explaining which assumption drives the result. Build a definition card for net debt, equity, EBITDA, and committed liquidity, because inconsistent definitions are the most common source of false comparisons. Finish each practice case with a decision threshold, such as a maximum leverage level or minimum cash buffer, and an action if that threshold is breached.
Build one three-period funding schedule that shows opening cash, operating inflow, investment outflow, debt maturity, new funding, and closing headroom. Recalculate it under delayed benefits and lower EBITDA. Explain whether the weakest point occurs before or after completion and which mitigation acts soon enough.
This timing exercise reveals why an acceptable terminal leverage ratio can coexist with an unsafe construction period, and it trains you to recommend sequencing rather than simply approving or rejecting the entire proposal.
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