Introduction to Capital Structure
Capital structure refers to the manner in which a company finances its assets using a combination of equity and debt.. It is the combination of various sources of funds that the corporation manages to finance its overall operations and growth. The corporation can use the debt source like long term bank loan, bond, long-term notes payable, or through equity sources that can be further classified as common stock, preferred stock, retained earnings and other comprehensive income.
Equity Capital refers to the funds that a firm’s owners are trusting with the company and the retained earnings refers to the earnings that are not distributed to shareholders as dividend. Debt Capital is the borrowed funds of a firm, usually long-term bonds.
When people refer to capital structure they are most likely referring to a firm’s debt-to-equity ratio, which provides insight into how risky a company is. Usually, a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.
Leverage Ratio examines the proportion of debt financing in the capital structure of a business. Debt structure as a percentage of equity financing or capital is Leverage Ratio.
- Leverage = Debt/Equity
- Leverage= Debt/Capital
Factors affecting Capital Structure
Firms’ capital structure is very subjective to the nature, direction, business cycle of business and various other internal and external factors. Some of the important factors that influence the capital structure are as follows;
Cash Flow Position
Cash and cash flow position of the company is one of the determinants affecting capital structure. The ability of firm to generate cash flow structure the capital composition. At times, company is better in terms of profitability but is not able to generate enough cash inflow for making payment and fulfilling obligations. In ideal situation, the expected cash flow must balance the obligation to be fulfilled and if the firm failed to make fixed payment, it may face insolvency situation.
If a company is confident in generating positive cash inflow then the company can go for more debt financing in capital structure. Company will have the ability to fulfill debt obligation from its cash flow. Similarly, if company lacks cash then company can go for equity financing in capital as there is no liability of the company to pay its shareholders.
Assets, backing the company also determine the capital structure of the company. A company with long term assets require long-term debt financing. Similarly, a company dealing with receivables and inventory i.e. may require short term financing. The nature of asset investment determines financing mixture. A company with a reserve of fixed asset may find easy to consider debt financing making assets as collateral. In contrary, a company may prefer going for equity financing when company has no backup.
Profitability is always crucial in business. As we say this, it also an important factor in determining the capital structure. A company with good Return on Investment (ROI) has an ability to consider the burden and benefits of debt financing given rate of interest low than ROI. To the contrary, when company has low ROI , the company should avoid debt and rely more on equity.
Operating leverage measures a company’s fixed cost as a percentage of its incurred total cost. Higher the value of fixed asset higher is the operating leverage and greater is the chance of business failure. Debt investment do not prefer higher operating leverage as it attracts higher risk. Also, higher risk due to leverage will increase the cost of debt.
Tax structure directly impact the debt factor of capital structure. In simple terms, the tax system may promote a more efficient capitalization of firms. High tax rates makes debt cheaper. The interest on debt is deducted from income making it appears as an expense while income calculation. This suggests, high tax rates prefer debt investment and low tax rate prefer equity investment in capital structure.
Capital restructuring is not easy for any business, So, it requires a lot of considerations. Interest rate on debt is major determinants for debt financing in business. If interest rate on debt is lower, businesses are likely to consider debt in capital and if cost of debt is high i.e. rate of interest on debt, company is less likely to prefer debt.
Corporate companies and financial institutions are among highly regulated sectors in an economy. The capital structure and composition are directly or indirectly managed by association of some kind or government. For instance, if a company wants to go for equity finance, it requires proper documentation and permission from regulators. Similarly, for debenture and long-term loans it requires to follow established banking guidelines and legal restrictions.
Similarly, there are state-wise, sector wise requirements for capital structure. There are benchmarks and ideal cases of capital structures which is predefined. There are different regulations for international companies and different for national companies planning to expand internationally. Hence, regulatory framework is crucial factor in capital structure.
Risk appetite of management is crucial. Management prefer debt financing in aggressive situation and when management is considering taking risk. Debt financing is comparatively easy to manage and there are multiple options for it in the market. Similarly, equity financing is subtle approach and is considered conservative.
More debt has higher risk and higher return whereas equity is more conventional in terms of taking risk and earning profits.
Some of the other factors affecting capital structure are;
- Risk consideration by Management and Business
- Control of business
- Nature of business
- Capital market conditions
- Growth prospect
- Competition in the market
- Economic condition