Capital Structure in Financial Management
Money is the most practical and basic requirement to start a company. The capital structure is the initial fund or money that one needs to start initial business activities. It is the foundation brick of business finance, depicting how you can use different sources of money to initiate growth and finance overall operations. To raise long-term business funds, an arrangement of money from different sources is needed, and this is known as the capital structure. It refers to the combination or proportions of preference share capital, equity share capital, long-term loans, debentures, retained earnings, and other funding sources in the total capital amount which a firm raises to run its business.
What is Capital Structure?
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A careful and intelligent balance between debt and equity is known as the capital structure from a technical point of view. Funds can be divided into two sectors. The first one is owner’s funds, followed by borrowed funds. The answer to the question of what is capital structure is that capital is a mixture of both, which a business uses to finance its day-to-day operations, growth, and assets. Owner’s funds or Equity includes Preference share capital, equity share capital, retained earnings, reserves, and surpluses. While debt or borrowed funds include public deposits, loans, and debentures.
When Does a Company Have Greater Investor Risks?
The true capital structure meaning is that it is a combination of long-term fund sources. Whenever the proportion of equity and debt maximizes the value of the company’s equity share, it is said that the capital structure is optimal. However, a company is said to have an aggressive capital structure if it is heavily funded by debt. Such firms have a greater risk to investors, but this can also be the primary source of the company's growth.
Comparing Equity and Debt
Debt vs. equity is a long-fought battle, and now we shall look into it in detail. On the other hand, debt is far riskier than equity because of the repayment of capital with assured interest that the lender earns. Another reason that supports the fact that debt is riskier is that debt interest is a tax-deductible expense. Therefore, it brings down the business’s tax liability, and after-tax dividends are paid out of profit. Liquidation of the company can occur in case of any failures related to repayment of the principal amount or interest payment. Debt undoubtedly adds to the financial risks faced by a business and is more dangerous.
Factors Affecting Capital Structure
There are various factors determining capital structure, and we shall look into each of them in detail.
Position Of Cash Flow: Debt capacity is the company’s ability to pay loans and expenses. If the company has a fluent cash flow position, then they may raise funds by issuing debts as they can be repaid in some time. The ability to meet financial obligations is affected if a firm operates in a volatile financial environment.
Interest Coverage Ratio: It is the ratio between EBIT or earnings before interest and tax and the interest itself. The company can have more borrowed money if this ratio is high.
Having Control: The company must issue debts as it does not cost dilution of control. Public issues can make the firm vulnerable and destroy its reputation. So there’s a constant turmoil whether to pay more for capital or give up control.
Investment Or Return: If the rate of interest on debt is lower than the return on investment, then the business can increase its finance through borrowed funds. But the company should go for equity if they are not sure if they can cover the fixed cost of interest.
Floatation Costs: This helps in determining the finance sources after you understand capital structure meaning. The floatation cost includes prospectus cost, broker’s commission, underwriter’s fee, security issuing costs, and more.
Stock Market: Determining securities is influenced by stock market conditions. Investors are ready to invest in equity shares and take a risk during the boom. But during times of depression, it’s exactly the opposite.
Flexibility: It can be incorporated by issuing preferences and debentures. A good financial plan should have the scope to contract or expand whenever required. Hence it should be sound enough and flexible.
Rate Of Tax: If the rate of tax is high, then debts are preferred over equity as interest on debt is allowed like a deduction. Again, if the rate is low, then equity gets the first preference.
FAQs on Capital Structure
1. What is Capital Structure, and How is it Different from Financial and Assets Structure?
The financial structure consists of long-term and short-term debts along with the shareholder’s fund, which occupies the entire left side of a company’s balance sheet. As per the capital structure meaning it consists of the shareholder’s fund and long-term debts. It can be said that the capital structure is a portion of the financial structure. But if the short-term debts are included in the capital structure, then there’s no difference between the two. The financial structure includes current liabilities which are not present in the capital. The asset structure, on the other hand, makes the assets side of the Balance Sheet. It is the sum of current assets in addition to fixed assets.
2. What is Financial Leverage and the Significance of Capital Structure?
Capital gearing or financial leverage is the proportion of debt in the total capital. Debt is a cheaper source of funds, so the cost of funds declines when overall firm debt increases. The firm is known as a highly levered firm when the debt proportion in the total capital is high. And, when the proportion is less, it is known as a low levered firm. Having a good capital structure increases market shares and hence increases the firm value. It also helps in having maximum profits and returns from the business and minimization of capital cost. A sound capital minimizes financial risks, allows expansion or contraction of debt capital, and provides scope for maximum utilization of available funds.