What is Capital structure?

Capital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm’s capital structure is typically expressed as a debt-to-equity or debt-to-capital ratio.

Debt and equity capital are used to fund a business’s operations, capital expenditures, acquisitions, and other investments. There are tradeoffs firms have to make when they decide whether to use debt or equity to finance operations, and managers will balance the two to find the optimal capital structure.

Capital structure refers to the composition of the company's assets. According to the balance sheet, assets = liabilities + equity. Where equity generally refers to the portion of the company that belongs to shareholders, and liabilities generally refer to the portion of the company that belongs to creditors. This is only a rough analogy, because there are some items in liabilities and equity that are not part of the capital structure that need to be eliminated.

There are always two ways to financing. The first one is to find a partner, draw an investment in and give him a part of the shares. The second one is to find a creditor which means borrowing money and promising to repay the principal and interest in the future, regardless of whether the company is profitable or not.

Importance of Capital Structure:

The importance or significance of Capital Structure:

1. Increase in value of the firm:

A sound capital structure of a company helps to increase the market price of shares and securities which, in turn, lead to increase in the value of the firm.

2. Utilisation of available funds:

A good capital structure enables a business enterprise to utilise the available funds fully. A properly designed capital structure ensures the determination of the financial requirements of the firm and raise the funds in such proportions from various sources for their best possible utilisation. A sound capital structure protects the business enterprise from over-capitalisation and under-capitalisation.

3. Maximisation of return:

A sound capital structure enables management to increase the profits of a company in the form of higher return to the equity shareholders i.e., increase in earnings per share. This can be done by the mechanism of trading on equity i.e., it refers to increase in the proportion of debt capital in the capital structure which is the cheapest source of capital. If the rate of return on capital employed (i.e., shareholders’ fund + long- term borrowings) exceeds the fixed rate of interest paid to debt-holders, the company is said to be trading on equity.

4. Minimisation of cost of capital:

A sound capital structure of any business enterprise maximises shareholders’ wealth through minimisation of the overall cost of capital. This can also be done by incorporating long-term debt capital in the capital structure as the cost of debt capital is lower than the cost of equity or preference share capital since the interest on debt is tax deductible.

5. Solvency or liquidity position:

A sound capital structure never allows a business enterprise to go for too much raising of debt capital because, at the time of poor earning, the solvency is disturbed for compulsory payment of interest to .the debt-supplier.

6. Flexibility:

A sound capital structure provides a room for expansion or reduction of debt capital so that, according to changing conditions, adjustment of capital can be made.

7. Undisturbed controlling:

A good capital structure does not allow the equity shareholders control on business to be diluted.

8. Minimisation of financial risk:

If debt component increases in the capital structure of a company, the financial risk (i.e., payment of fixed interest charges and repayment of principal amount of debt in time) will also increase. A sound capital structure protects a business enterprise from such financial risk through a judicious mix of debt and equity in the capital structure.

Factors Determining Capital Structure

1. Trading on Equity

The word “equity” denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of company’s earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high.

2. Degree of control

In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.

3. Flexibility of financial plan

In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans.

4. Choice of investors

The company’s policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors.

5. Capital market condition

In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the company’s capital structure generally consists of debentures and loans. While in period of boons and inflation, the company’s capital should consist of share capital generally equity shares.

6. Period of financing

When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures.

7. Cost of financing

In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits.

8. Stability of sales

An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases.

9. Sizes of a company

Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.