What is the most basic and practical thing required to start a company? Yes, it is money. Capital is the fund required to initiate the activities of any business. It is the foundation of business finance. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.
From a technical perspective, the capital structure is the careful balance between equity and debt that a business uses to finance its assets, day-to-day operations, and future growth. Capital Structure is the mix between owner’s funds and borrowed funds.
- FUNDS = Owner’s funds + Borrowed funds.
- Owner’s funds = Equity share capital + Preference share capital + reserves and surpluses + retained earnings = EQUITY
- Borrowed funds = Loans + Debentures + Public deposits = DEBT
In short, Capital Structure is the mixture of long-term sources of funds. Capital Structure is optimal when the proportion of debt and equity maximizes the value of the equity share of the company. However, a company heavily funded by debt has an aggressive capital structure and poses a greater risk to investors. This risk, however, may be the primary source of the firm’s growth.
Debt vs Equity
Cost of Debt is lower than the cost of equity but Debt is riskier than equity. The reasons for this are
- Lender earns an assured interest and repayment of capital.
- Interest on debt is a tax-deductible expense so brings down the tax liability for a business whereas dividends are paid out of profit after tax.
Debt is more dangerous for the business as it adds to the financial risk faced by a business. Any failure with reference to the payment of interest or repayment of principal amount may lead to the liquidation of the company.
Browse more Topics under Financial Management
- Meaning of Business Finance
- Financial Management and Objectives of Financial Management
- Financial Planning
- Financing Decision
The proportion of debt in the overall capital of a firm is called Financial Leverage or Capital Gearing. When overall debt in the firm increases, cost of funds declines as debt is a cheaper source of funds.
When the proportion of debt in the total capital is high then the firm is called highly levered firm but when the proportion of debts in the total capital is less, then the firm will be called low levered firm.
Factors Affecting Capital Structure
1] Cash Flow Position
A firm’s ability to pay expenses and loans determines debt capacity. Some firms operate in volatile financial environments affecting their ability to meet financial obligations. The company may raise funds by issuing debts if it has a fluent cash flow position, as they are to be paid back after some time.
It must cover fixed payment obligations with regards to,
- Normal business operations
- Investment in fixed assets
- Meeting debt services commitments as well as provide a sufficient buffer period
2] Interest Coverage Ratio
Interest Coverage Ratio is the number of times earnings before interest and taxes of a company covers the interest obligation. High-Interest coverage ratio indicates that company can have more of borrowed funds.
Interest Coverage Ratio (ICR) = Earnings Before Interest and Tax (EBIT) / Interest.
Public issues damage the reputation of the firm and make it vulnerable to takeovers. Debt generally does not cost dilution of control. To have control, the firm must issue debt. So there is a constant struggle over whether to give up control or pay more for capital.
4] Return on Investment
It will be beneficial for a firm to raise finance through borrowed funds if the return on investment is higher than the rate of interest on the debt. But if the return is uncertain and the company is not sure if it can cover the fixed cost of interest, they should opt for equity.
5] Floatation Cost
Flotation cost must be understood while selecting the sources of finance. Cost of the Public issue is more than the floatation cost of taking a loan. The cost of issuing securities, brokers’ commission, underwriter’s fee, cost of prospectus etc is the flotation cost.
Issuing debenture and preference shares introduce flexibility. A good financial structure is flexible and sound enough to have scope for expansion or contraction of capitalization whenever the need arises.
7] Stock Market Conditions
Conditions of the stock market influence the determination of securities. During the depression, people do not like to take a risk and do not take interest in the equity shares. During the boom, investors are ready to take a risk and invest in equity shares.
8] Tax Rate
Interest on debt is allowed as a deduction; thus in case of the high tax rate, debts are preferred over equity but in case of low tax rate more preference is given to equity.
Solved Question for You
Question: Explain high levered firm and a low levered firm?
Answer: A high levered firm is when the proportion of debt in the total capital is high. A low levered firm is when the proportion of debt in the total capital is low.