Financial Structure Meaning
The financial structure refers to sources of capital and its proportion of financing coming from short term liabilities, short term debt, long term debt as well as from equity to fund the long term as well as short term working capital requirements of the company.
- Debt includes a loan or other borrowed money that has an interest component associated with it which is periodically paid till the borrowed amount is fully repaid.
- Equity refers to diluting the owner’s stake in the company and selling it to investors. Equity investor does not need to be paid interest like debt, rather the profit earned by a company is attributed to them as they own a share in the company and are part owners. Profit is distributed through dividends paid by the company to its investors.
Optimal Financial Structure
While every company or firm, private or public, is free to use any kind of structure but any or random mix of debt and equity is neither preferable nor good for a going concern company. The kind of structure a company employs affects its WACC (Weighted average cost of capital) which directly affects the valuation of a company. Therefore an optimal structure is necessary to maximize the value of a company. WACC is the weighted average of the marginal cost of financing for each type of financing used.
Formula for WACC is
WACC = Ke*We + Kd(1-tax rate)*Wd
- Ke = Cost of equity
- We = Weight/Proportion of equity in the financial structure
- Kd = Cost of debt
- Wd = Weight/Proportion of debt in the financial structure
For eg: a company named ABC ltd. has a total capital of $1 million structure with $500,000 each of equity and debt. Both equity and debt come with a cost. Cost of debt is interest paid while the cost of equity is the minimum return that an investor would expect. Assume the cost of equity is 12% and cost of debt at 8% and the tax rate at 30%, so the WACC of ABC ltd is
- WACC = .12*(500,000/1,000,000)+.08*(1-0.3)*(500,000/1,000,000)
- =.088 or 8.8%
Some may argue against debt as to why to use it and pay interest on it? There are many reasons for it like a firm may not have equity to finance its business activity and will finance it with debt. Another reason is due to the lower effective cost of debt than equity which reduces WACC and increases valuation and amplifies certain profitability ratios like return on equity. How the cost of debt is less than the cost of equity can be explained with the following example-
Suppose a company needs capital of $100,000 for its business operations, so a company can either issue debt of $100,000 at a 10% interest rate or it can dilute its equity by 10%. As mentioned and calculated below, the company going with the debt financing route pays 10% interest on $100,000 of $10,000 and earns a profit of $273,000. Whereas the company going through equity financing route will generate a profit of $280,000 due to nil interest cost but the net profit attributable to the owner would be only $252000 ($280,000-10%*280,000) as owner owns only 90% of the company and 10% is owned by someone else due to sale of 10% equity.
So the profit from debt financing is greater than equity financing due to less cost associated with debt and also because of its tax-deductible feature.
Again, one should keep in mind about the inherent financial risk debt brings with itself, there are no free lunches and therefore risk with debt is also higher. The optimal level of leverage thereby is when the value-enhancing effect of additional debt is offset by its value reducing the effect.
Factors Affecting Financial Structure
Various factors affect financial structure decisions. Some of them are explained below:
- Cost of Capital – As discussed above, debt and preference shares are a cheaper source of capital than equity and the focus of a company is on reducing its cost of capital.
- Control – Equity as a source of capital has its limitations. The excessive dilution or selling of stake may lead to loss of power in decision making and controlling stake in a company.
- Leverage – Debt can be both positive and negative. On the positive side, it helps in keeping low cost of capital as it is a cheaper source than equity and a small increase in profit magnifies certain return ratios, on the negative side it may create solvency issues and increases the financial risk for the company.
- Flexibility – The financial structure should be arranged in such a manner that it can be altered along with the changing environment. Too much rigidity may make it difficult for a company to survive.
- Credibility & Size of a Company – Small-sized companies or new companies or companies with a bad credit history may not have unrestricted access to the debt due to insignificant cash flows, lack of assets and a missing guarantor for the security of a loan. Therefore it may be forced to dilute its equity to raise capital.
Financial Structure v/s Capital Structure
Some people confuse financial structure with capital structure. Although there are many similarities, there is a slight difference between them. The financial structure is a broader term than capital structure.
The financial structure includes long term as well as short term sources of funds and contains the whole of liabilities and equities side on balance sheet. Whereas, the capital structure includes only long term sources of the fund like equity, bond, debentures, other long term borrowings and not accounts payable and short term borrowings. So basically capital structure is a section of financial structure.
Advantages of Debt Financing
Although excess debt increases financial risk to the firm, reasonable debt has its advantages-
- Debt financing allows the promoter and owners to retain ownership and control over the company.
- The owner is free to make a decision like allocation of capital or retention of profits, dividend distribution etc. without any interference from lenders as long as timely payment is made to them.
- In the long term, debt financing is less costly than equity which lowers the cost of capital.
- Debt obligations exist until the loan is repaid after which the lender can have no claim to the business.
Disadvantages of Debt Financing
- It has to be paid at regular time intervals failing which may invite heavy penalties and lower credit rating.
- Debt is limited to established companies, and young companies which face the shortage of cash flows in initial periods, have difficulty in access to debt.
- Debt financing also increases financial risk to the company.
Advantages of Equity Financing
- A company following the equity financing route has no obligation to repay money as in case of debt. Their risk and rewards are aligned with a company’s performance. If the company grows and earns a profit, equity owners have their share in those profits and if the company goes bankrupt, then the equity owner loses all of its value equal to their shareholding.
- Young, newly formed or unproven companies can acquire equity financing with much ease than debt financing due to lack of assets, credit history, etc.
- Equity financing brings new investors to the table which often provides management guidance and advice for existing owners.
Disadvantages of Equity Financing
- Capital raised by diluting equity stake leads to less control and decision making power over the company.
- Too many stakeholders with different ideas can delay the decision-making process and pose a problem in day to day business operations.
- Equity financing compared to debt financing is a complex and sometimes expensive process like in case of an IPO (Initial Public Offer)
- Equity financing as explained earlier is costly than debt financing which increases the cost of capital.
Financial structure gives an insight into leverage and cost of capital of a company. An asset to equity, Debt to equity, etc. are some ratios that give an idea about financial structure. In initial years, many companies may deviate from their target or optimal capital structure due to need of funds and therefore may not think about the sources of funds.
But in the long term, every company move towards their target or optimal capital structure whereby the cost of capital is minimized and the value of a firm is maximized.
This has been a guide to Financial Structure and its meaning. Here we discuss factors affecting the financial structure, its differences from capital structure along with advantages and disadvantages. You can learn more from the following articles –