What is Capital Structure?
Capital structure is the composition of a company’s sources of funds, a mix of owner’s capital (equity) and loan (debt) from outsiders. It is used to finance its overall operations and investment activities. The owner’s capital is in the form of equity shares (common stock), preference shares (preference stock), or any other form that is eligible to control the entity’s retained earnings Retained 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 bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period. or Please provide us with an attribution link[/wsm-img-crd-tooltip]
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Table of contents
- Capital structure refers to the composition of a company’s sources of funds, a combination of owner’s capital(equity) and loan (debt) from outsiders. One may use it to finance overall business operations and investment activities.
- The types of capital structure are equity share capital, debt, preference share capital, and vendor finance.
- In addition, it ensures accurate funds utilization for business. The right capital structure level decreases the overall capital cost to the highest level. Also, it increases the public entity’s valuation.
- If the debt-equity ratio is low, the firms may borrow the new debt amount. If the company has adequate cash reserve, it can repay the existing debt and borrow the new debt capital at a reduced interest rate.
Capital Structure Explained
Capital structure is a specific mix of equity and debt used to finance a company’s operations and assets. From a corporate finance perspective, equity capital provides a more long-term and flexible source of finance for the company’s growth prospects and daily transactions.An optimal capital structure comprises of enough balance between equity and debt. Debt for an organization includes all short-term and long-term loans that the company has to repay. Equity is the combination of common and preferred shares and their retained earnings.
Let us understand the intricacies of this concept through discussions about types, formula, examples, and importance.
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The formula of capital structure formula quantifies the amount of equity and the amount of outsiders’ capital at a point in time. We can do such calculations as a percentage of each money to the total capital or debt-to-equity ratioDebt-to-equity RatioThe 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 the Debt/Equity formula.
A company with a higher debt-equity ratio is a highly leveraged company.
Let us understand the concept in detail through the couple of examples with calculation below which will help us understand the optimal capital structure.You can download this Capital Structure Excel Template here – Capital Structure Excel Template
A company has proposed an investmentInvestmentInvestments are typically assets bought at present with the expectation of higher returns in the future. Its consumption is foregone now for benefits that investors can reap from it later. in a project with information about its project cost. The project will be financed 20% by the common stock, 10% by the preferred stock, and 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: The debt-equity share has been reducing over the years since the reserves increased, and the company can repay its debt holders.
Based on the nature of business, management style, and the risk appetite of the organization, the capital structure theory might differ. Let us understand the different types through the discussion below.
#1 – Equity Share Capital
- It is the most common form of the capital structure, wherein the owner’s contribution is reflected. It is the first amount the owners introduce into the entity’s business.
- 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 business’s retained earnings after paid preference shareholders.
- Retained earnings are nothing but an accumulation of profitsProfitsProfit refers to the earnings that an individual or business takes home after all the costs are paid. In economics, the term is associated with monetary gains. over the years. In the entity’s 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., 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 pay interest before paying 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 Cost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.. 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 the financing cost and 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 debt is treated as debt for the company and displayed under the heading “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. and not calculated by the debt-equity ratio.
- In liquidation of the entity, debt holders can prefer payment before the entity’s shareholders.
#3 – Preference Share Capital
- Preference share capitalShare CapitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side. is a mediatory form of capital wherein they are shareholders of the entity with a preference over the common stockholders.
- Here, preference means preference in the case of dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity. payment and preference over capital repayment (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 days to 90 days. In the case of vendorVendorA vendor refers to an individual or an entity that sells products and services to businesses or consumers. It receives payments in exchange for making items available to end-users. They constitute an integral part of the supply chain management for providing raw materials to manufacturers and finished goods to customers. financing, the goods are supplied with a long period of credit to the entity.
- It reduces the cost of finance Cost 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 structure since the interest meter starts after the credit period and at a lower interest rate than normal debt capital.
Let us understand the importance of the capital structure theory through the points below.
- Business increases 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 Return 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..
- The market always rewards a balanced capital structure, reflected in the share price.
- It further ensures the appropriate utilization of funds for business.
- The right level of capital structure minimizes the overall cost of capital to an optimum level.
- The appropriate capital structure level increases the public entity’s valuation.
- If the debt-equity ratio is lower, the firm gets the flexibility to borrow the new amount of debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state..
- If the company is flooded with sufficient cash reserves, it can repay the existing debt and borrow new debt capital at a reduced interest rate.
Frequently Asked Questions (FAQs)What are the factors affecting capital structure?
The factors affecting capital structure are the firm’s capital cost, size, nature, capital markets situation, ownership, and debt-to-equity ratio.What is the capital structure financial management?
Capital structure financial management refers to the definite combination of debt and equity that one may use to finance the company’s business operations and assets. Equity may prove more expensive to corporates and can be a capital’s permanent source with higher financial elasticity.What are the determinants of capital structure?
The determinants of capital structure are profitability, size, growth, tangibility, tax shield, and age.What is the capital structure decision?
Capital structure decisions involve long-term finds sources like debt and equity capital. It combines different long-term funds sources, divided into debt and equity. Therefore, it is also known as the company’s “Debt Equity Mix.”
This article is a guide to what is Capital Structure. We explain its examples, formula, types, calculation, and its importance. You may learn more about financing from the following articles: –