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 earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company. of the entity. Debt capital is in the form of the issue of bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually. or debentures of loans from a financial banker. Capital structure is a very critical factor in the case of project financingProject FinancingProject Finance is long-term debt finance offered for large infrastructure projects depending upon their projected cash flows. Moreover, an investor has to form a Special Purpose Vehicle (SPV) to acquire the same. . 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 equityDebt To EquityThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. .
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.
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 shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. 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 liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order. 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 payableInterest PayableInterest Payable is the amount of expense that has been incurred but not yet paid. It is a liability that appears on the company's balance sheet. 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 statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. 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 liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc. & 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 dividendDividendDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company. & preference over repayment of capital (in case of liquidation of the entity)
#4 – Vendor Finance
- Vendor FinanceVendor FinanceVendor Financing, also known as trade credit, is lending of money by the vendor to its customers who in turn use the money to buy products/services from the same vendor. Vendor Financing is when the borrower uses the borrowed amount for goods/services from the lender itself. The vendor gives a line of credit to its customer based on their goodwill and rapport. 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 periodCredit PeriodCredit period refers to the duration of time that a seller gives the buyer to pay off the amount of the product that he or she purchased from the seller. It consists of three components - credit analysis, credit/sales terms and collection policy. 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 financeCost Of FinanceFinancing costs refer to interest payments and other expenses incurred by the company for the operations and working management. An enterprise often borrows money from different financing sources to run their operations in return for interest payments and capital gains. 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 employedReturn On Capital EmployedReturn on Capital Employed (ROCE) is a metric that analyses how effectively a company uses its capital and, as a result, indicates long-term profitability. ROCE=EBIT/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 –