Financial structure refers to the way as to how the firm’s assets are financed. It includes both, long-term as well as short-term sources of funds. In other words, it refers to the left hand side of the Balance Sheet as represented by total liabilities. However, a more frequently used term is capital structure which is slightly different from financial structure. If short-term liabilities are removed from firm’s financial structure, what one obtains is its capital structure.
So, financial structure is defined as the amount of current liabilities, long-term debt, preferred stock and common stock used to finance a firm. In contrast, capital structure refers to the amount of long-term debt, preferred stock and common stock used to finance a firm’s assets. Thus, capital structure is only a part of the financial structure and it represents the permanent financing of the company. Another term Capitalization refers to total long-term funds required by the firm. Whereas, capital structure refers to ‘make-up of capitalization’ i.e. types and proportion of different securities to be issued.
There cannot be a uniform financial structure which suits the requirements of all firms. In other words the financial structure has to be formed in such a way that it suits the needs of a particular firm meaning thereby that the firm should seek an optimum or an ideal financial structure for itself. Financial structure particularly the capital structure decision is a significant financial decision since it affects the shareholders’ return and risk and consequently the market value of the firm. The use of fixed charges capital like debt with equity capital is described as financial leverage or trading on equity. The main reason for using financial leverage is to increase the shareholders’ return.
The concept of financial structure can be studied initially from the point of view of the length of time for which money is needed. The requirement of finance of an enterprise can be divided into three parts, i.e. long-term finance, medium-term finance and short-term finance. However, opinion is not consistent regarding the duration of each type of finance. The dividing line amongst these types of finance is thin and arbitrary. But generally, the need of funds for not more than one year is included in short term finance, for more than one year but not exceeding five years are included in medium term finance and those for over five years are included in long term finance. Long-term finance consists of equity share capital, preference share capital (except redeemable preference shares), irredeemable debentures and long term loans from government, financial and commercial institutions. It is invested in permanent and semi-permanent assets. For a new concern this is required for purchase of fixed assets, meeting the requirement of some part of working capital and for raising the structure of the organization. For an existing company, it is required for expansion, development, modernization, industrial research, special campaign like advertisement etc.
The medium term finance occupies the ‘in between’ position. It is that finance which is to be retained in the business enterprise for a period longer than one year but it is not intended to retain permanently. It is defined as debt originally scheduled for repayment in more than one year but not more than five years. Some Management Accountants are of the opinion that it must not exceed five years while others assert this limit as ten years. The major sources of medium term finance are term loans and advances and redeemable preference shares and debentures. Commonly, medium term finance is used for tools, office equipment, furniture, additions and alterations in building etc.
Short-term finance refers to the finance required for use in the business for not more than a year. The main sources of short-term finance are commercial banks, credit facilities between firms and acceptance credits. Current liabilities and provisions represent these sources of short-term finance. The basic characteristics of the short-term finance are that ones which primarily stand for very low cost and low risk capital. Short-term finance is invested in the current assets as a matter of policy, because the current assets are automatically converted into cash during routine business operations.
All the industries require more or less long term and medium term debt capital. Apart from own capital, it is advantageous to use debt capital as a matter of policy in order to avail the benefit of trading on equity. Similarly, long-term funds should be used prudently in order to avoid lack of liquid sources for current liabilities. Thus, optimum financial structure consists of proper mix among long-term, medium-term and short-term finance.