Meaning of Capital Structure

Capital structure refers to the portfolio of different sources of capital employed by a business. It is the mix of capital. It is the portfolio of liabilities of business. It is the structure of long term liabilities of a business. Short term liabilities being fluctuating type, for structure analysis, which is some what long term in nature, are not considered for capital structure analysis. There is another concept viz., financial structure which studies the structure of whole of the liabilities of business including both short term and long term capital. In final analysis, capital structure analysis is considered with the equity and debt composition of capital of a business.

The capital structure for a business should be planned. The debt-equity proposition, mix of equity sources, mix of debt sources and the like need to be planned. To plan capital structure, therefore, means determining the debt-equity proportion and mix of individual components of equity (paid equity and earned equity, that is ratio of paid up equity capital to retained earnings) and mix of debt capital types (bank loan, debentures, public deposits, etc.,) so that the firm is optimally capitalized. Optimum capital structure is one that maximizes value of business, minimizes overall cost of capital, that is flexible, simple and futuristic, that ensures adequate control on affairs of the business by the owners and so on. To reap the above benefits without accompanying costs, planning of capital structure is needed.

The primary advantage of debt financing is that it allows the founders to retain ownership and control of the company. Debt obligations are limited to the loan repayment period, after which the lender has no further claim on the business, whereas equity investors’ claim does not end until their stock is sold. Debt financing tends to be less expensive for small businesses over the long term, though more expensive over the short term, than equity financing. The major disadvantage is that it requires a small business to make regular monthly payments of principal and interest. Very young companies often experience shortages in cash flow that may make such regular payments difficult. Another disadvantage associated with debt financing is that its availability is often limited to established businesses. Since lenders primarily seek security for their funds, it can be difficult for unproven businesses to obtain loans.

The main advantage of equity financing for small businesses is that there is no obligation to repay the money. Equity financing is also more likely to be available to concept and early stage businesses than debt financing. Another advantage of equity financing is that investors often prove to be good sources of advice and contacts for small business owners. The main disadvantage of equity financing is that the founders must give up some control of the business. If investors have different ideas about the company’s strategic direction or day-to-day operations, they can pose problems for the entrepreneur. In addition, some sales of equity, such as initial public offerings, can be very complex and expensive to administer. Such equity financing may require complicated legal filings and a great deal of paperwork to comply with various regulations.

Features of a Capital Structure

Capital structure is that level of debt-equity proportion where the market value per-share is maximum and the cost of capital is minimum.

It should have the following features:

• Profitability/Return: Studies have shown that the relationship between debt-equity ratio and a firm’s profit margin is such that for a firm which prefers to finance its investments through self-finance are more profitable than firms which finance investment through borrowed capital, firms prefer competing with each other than cooperating and firms use their investment in fixed assets as a strategic variable to affect profitability.
• Solvency/Risk: Capital Structure of a firm indicates how much the company is leveraged by comparing what it owes to creditors and investors to what it owns. It reveals the degree to which the company’s management is willing to fund its operations with debt, rather than equity. Lenders are sensitive about this feature as a high debt-equity ratio will put their loans at risk of being unpaid.
• Flexibility: Flexibility is the ability to make decisions that the firm thinks are most apt even when others disagree. The level of flexibility the management can have depends on how the firm is financed. Debt offers little flexibility relative to equity. However, the flexibility offered by equity depends on the extent to which shareholders are inclined to agree with management’s strategic choices. The flexibility benefit of equity is high only when the share price is high.
• Conservation/Capacity: If a firm starts with a specific business risk, then the total risk associated with stock and debt is not affected by the capital structure. This is called ‘conservation of risk’. Risk is neither created nor destroyed. Debt capacity involves the assessment of the amount of debt that the organization can repay in a timely manner without forfeiting its financial viability.
• Control: The capital structure of a firm shows when control is allocated to only shareholders and when to others like creditors, or the management team. Generally the shareholders get control when the firm’s cash flow is sensitive. Also , debt value and firm value are negatively correlated when debt-holders have veto power.

Determinants of Capital Structure

Capital structure of a firm is determined by various internal and external factors. The macro variables of the economy are inflation rate, tax policy of government, capital market condition. The characteristics of an individual firm, termed as micro factors (internal), also affect the capital structure of enterprises.

Read more: Determinants of Capital Structure

Forms of Capital Structure

Capital Structure can be of various forms:

• Horizontal capital Structure: The firm has no component of debt in the financial mix. Expansion of the firm is through equity and retained earnings only.
• Vertical Capital Structures: The base of the structure is a little amount of equity share capital which serves as the foundation for a super structure of preference share capital and debt.
• Pyramid Shaped Capital Structure: Large proportion consisting of equity capital and retained earnings.
• Inverted Pyramid shaped Capital Structure: Small component of equity capital, reasonable retained earnings and increasing component of debt.