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.
introduction of Capital Structure
Both debt and equity can be found on the balance sheet. Company assets, also listed on the balance sheet, are purchased with debt or equity. Capital structure can be a mixture of a company’s long-term debt, short-term debt, common stock, and preferred stock. A company’s proportion of short-term debt versus long-term debt is considered when analyzing its capital structure.
When analysts refer to capital structure, they are most likely referring to a firm’s debt-to-equity (D/E) ratio, which provides insight into how risky a company’s borrowing practices are. Usually, a company that is heavily financed by debt has a more aggressive capital structure and therefore poses a greater risk to investors. This risk, however, may be the primary source of the firm’s growth.
Debt is one of the two main ways a company can raise money in the capital markets. Companies benefit from debt because of its tax advantages; interest payments made as a result of borrowing funds may be tax-deductible. Debt also allows a company or business to retain ownership, unlike equity. Additionally, in times of low-interest rates, debt is abundant and easy to access.
Equity allows outside investors to take partial ownership of the company. Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back. This is a benefit to the company in the case of declining earnings. On the other hand, equity represents a claim by the owner on the future earnings of the company.
Importance of Capital Structure
- Capital structure is vital for a firm as it determines the overall stability of a firm. Here are some of the other factors that highlight the importance of capital structure
- A firm having a sound capital structure has a higher chance of increasing the market price of the shares and securities that it possesses. It will lead to a higher valuation in the market.
- A good capital structure ensures that the available funds are used effectively. It prevents over or under capitalisation.
- It helps the company in increasing its profits in the form of higher returns to stakeholders.
- A proper capital structure helps in maximising shareholder’s capital while minimising the overall cost of the capital.
- A good capital structure provides firms with the flexibility of increasing or decreasing the debt capital as per the situation.
Factors Determining Capital Structure
Following are the factors that play an important role in determining the capital structure:
Costs of capital: It is the cost that is incurred in raising capital from different fund sources. A firm or a business should generate sufficient revenue so that the cost of capital can be met and growth can be financed.
Degree of Control: The equity shareholders have more rights in a company than the preference shareholders or the debenture shareholders. The capital structure of a firm will be determined by the type of shareholders and the limit of their voting rights.
Trading on Equity: For a firm which uses more equity as a source of finance to borrow new funds to increase returns. Trading on equity is said to occur when the rate of return on total capital is more than the rate of interest paid on debentures or rate of interest on the new debt borrowed.
Government Policies: The capital structure is also impacted by the rules and policies set by the government. Changes in monetary and fiscal policies result in bringing about changes in capital structure decisions.
Companies that use more debt than equity to finance their assets and fund operating activities have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure.
That said, a high leverage ratio and an aggressive capital structure can also lead to higher growth rates, whereas a conservative capital structure can lead to lower growth rates.
Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total liabilities by total equity. Savvy companies have learned to incorporate both debt and equity into their corporate strategies. At times, however, companies may rely too heavily on external funding and debt in particular.
Investors can monitor a firm’s capital structure by tracking the D/E ratio and comparing it against the company’s industry peers.