What is Capital Structure?
Capital Structure is the composition of company’s sources of funds, which is a mix of owner’s capital (equity) and loan (debt) from outsiders and is used to finance its overall operations and investment activities.
The owner’s capital is in the form of equity shares (i.e. common stock), preference shares (i.e. preference stock), or any other form which is eligible to take control over the retained earnings of the entity. Debt capital is in the form of the issue of bonds or debentures of loans from a financial banker. Capital structure is a very critical factor in the case of project financing. The bankers are much concerned about the initial percentage of funding to the proposed project and usually assist up to 70% of the project cost.
Capital Structure Formula
The formula of capital structure quantifies the amount of equity and the amount of outsiders’ capital at a point in time. We can do such calculations in a simple form, as a percentage of each capital to the total capital or the ratio of debt to equity.
Let us calculate capital structure using Debt/Equity formula
A company with a higher debt-equity ratio is said to be a highly leveraged company.
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Examples of Capital Structure
Lets’ say a company has proposed investment in a project with the following information about its project cost. The project will be financed 20% by the common stock, 10% by the preferred stock & the rest by the debt. The company intends to understand its calculations.
Debt Equity will be –
Debt Equity Ratio = (1794/769) = 2.33
The capital structure of the entity over the projected years is as follows:
Note: Over the years, the debt-equity share is reducing since the reserves are increasing, and the company is able to repay its debt holders.
Types of Capital Structure
#1 – Equity Share Capital
- It is the most common form of the capital structure, wherein the owner’s contribution is reflected. It the first amount introduced by the owners into the business of the entity.
- The equity shareholders have the right over the retained earnings of the business after the preference shareholders are paid.
- Retained earnings are nothing but an accumulation of profits over the years. In the case of liquidation of the entity, the equity shareholders will be the last people to be paid.
#2 – Debt
- Debt is the amount borrowed by the entity from the outsiders for business. The debt holders are liable to paid interest before payment of taxes to the government.
- Interest payable to these holders is called a cost of debt. In the case of a new business/project, the cost of debt is the minimum percentage return to be achieved from the project each year. In the case of well-settled enterprises, the cost of debt is treated as a part of financing cost & shown separately in the financial statements of an entity.
- Usually, only the long-term form of debt is treated as debt for the company & shown under the head “Non-current liabilities”. Short-term debt is treated as current liabilities & not taken in the calculation of the debt-equity ratio.
- In case of liquidation of the entity, debt holders can preference payment before the shareholders of the entity.
#3 – Preference Share Capital
- Preference share capital is a mediatory form of capital wherein they are shareholders of the entity with a preference over the common stockholders of the entity.
- Here, preference means preference in case of payment of dividend & preference over repayment of capital (in case of liquidation of the entity)
#4 – Vendor Finance
- Vendor Finance is the least known form of the capital structure wherein the suppliers will provide the goods on long term credit to the entity.
- The standard credit period is around 60 to 90 days. In the case of vendor financing, the goods are supplied with a long period of credit to the entity.
- It reduces the cost of finance for the entity since the interest meter starts after the credit period & at a lower rate of interest as compared to normal debt capital.
Why is it Important?
- Business increases only when it has a higher amount of funds for disposal. Debt provides higher leverage for the entity and is therefore essential to increase the return on capital employed.
- A balanced form of capital structure is always rewarded by the market, reflected in the share price.
- It further ensures the appropriate utilisation of funds for the purpose of business.
- The appropriate level of capital structure minimises the overall cost of capital to an optimum level.
- The appropriate level of the capital structure increases the valuation of the overall entity.
- In case the debt-equity ratio is lower, the firm gets the flexibility to borrow the new amount of debt.
- In case the company is flooded with sufficient cash reserves, it can pay off the existing debt and borrow new debt capital at a reduced interest rate.
This article has been a guide to what is capital structure and its meaning. Here we discuss its formula, examples, types and why it is important? You may learn more about financing from the following articles –