What is the most practical and important criterion for starting a company? Yes, it is always money. Capital is what you need in every step of establishing and running a business. The capital structure is the way a firm manages its overall operations financially.
What is capital structure?
From a technical viewpoint, the capital structure is the delicate balance between debt and equity. It consists of both the borrowed funds and own funds of the owner. To shorten it, capital structure is basically the mixture of the company’s long-term funds sources. So, a company having major debts has an uncertain capital structure, posing immense risks to the major investors.
Debt or Equity:
Debt cost is always lower than equity cost. But, debt is also riskier as opposed to equity. The reasons behind this are:
- Lender earns a guaranteed repayment of the capital along with interest
- The amount the company pays as interest is tax-deductible and it brings down the business’s tax liability. But, dividends need to be paid from profit after clearance of tax
Therefore, the dangers associated with debt are more as it adds to the future economic threats faced by the company.
The debt’s specific proportion in the firm’s overall capital is known as Capital Gearing or Financial Leverage. As overall debt rises, funds’ cost declines, as debt is among the cheap sources of money.
Based on the above-mentioned principle, when debt proportion is less in the total capital, we call the firm a low levered one. On the other hand, when overall debt’s proportion is high in the total capital, the firm is considered highly leveraged.
Factors that affect capital structure:
- Position of cash flow- A firm’s capability to pay loans and other expenses is known as its debt capacity.
If has to fulfill fixed payment liabilities with regards to,
- Daily business operations
- Meeting debt commitments
- Investment in all fixed assets
- Control- Public issues have the potential of damaging a firm’s reputation, making it vulnerable to immediate or delayed takeovers. To exert control, the firm needs to issue debt. So, there is an unending struggle between whether to pay more money for capital or compromise with control.
- Investment returns- It will prove beneficial for any company to raise money through its borrowed finances.
- Flexibility- Issuing preference shares and debenture introduce flexibility. A proper financial structure has the flexibility to contract or expand capitalization whenever the situation demands.
- Floatation costs- One needs to understand the floatation cost while choosing finance sources.
- Stock market scenario- The scenario in the stock market has influence on the securities. During depression, most people avoid risks and therefore, do not purchase equity shares. In good times, all investors become daring and invest money in equity shares.
Tax rate- If the tax rate is high, debts get preference over equity. On the contrary, in case of low tax rate, equity gets more preference than debt.