What is Capital Structure?
The term “capital structure” refers to the mix of debt and equity that a company employs to fund its business growth. Debt is usually raised in bank loans, bond issues, or commercial papers, while the most common equity sources are common stock, preferred stock, or retained earnings. Typically, a company’s capital structure is expressed as a debt-to-equity ratio or debt-to-capital ratio.
Features of Capital Structure
Some of the key features of a suitable capital structure of a company are as follows:
- Flexibility: It provides flexibility in terms of financing options such that the finance manager can alter the debt-equity mix based on the need of the hour. For instance, a growing company might employ higher debt while a mature company would rely more on equity.
- Profitability: A sound capital structure can be leveraged to improve profitability, translating into higher earnings per share. The use of an optimum capital structure can result in maximum leverage at minimum cost.
- Solvency: Excessive debt or very high leverage can be threatening to a company’s solvency and credit rating. The portion of debt in a capital structure should be limited to the extent that the company can comfortably serve.
- Conservatism: The company should be conservative and ensure that they don’t exceed their debt capacity because any debt entails principal repayment and periodic interest payment that depends on future cash flows. If the future cash flows are not adequate for debt servicing, then it can result in legal insolvency.
- Control: Increase in leverage means a higher amount of debt that might lead to business owners relinquishing control of the company in the case of inability to repay. Hence, the capital structure should be such that it doesn’t lead to a loss of control in the company.
Examples of Capital Structure (With Excel Template)
Below are the different examples:
Example #1
Let us assume that a company is planning to invest in an expansion project. The project will be financed 35% through equity infusion, and the remaining funding will be through bank loans. Determine the debt-to-equity ratio of the project based on the given information.
Solution:
Debt Component is calculated using the formula given below
Debt Component = 1 – Equity Component
- Debt Component = 1 – 35%
- Debt Component = 65%
The debt-to-equity ratio of the project is calculated using the formula given below.
Debt-to-equity Ratio = Debt Component / Equity Component
- Debt-to-equity Ratio = 65% / 35%
- Debt-to-equity Ratio = 1.86x
Therefore, the debt-to-equity ratio of the project is 1.86x.
Example #2
Let us take the example of a company that is engaged in a trading business. The company has an outstanding cash credit of $4.5 million, a term loan of $0.25 million, and a tangible net worth of $1.5 million. Determine the company’s debt-to-equity ratio based on the given information.
Solution:
Debt is calculated using the formula given below
Debt = Cash Credit + Term Loan
- Debt = $4.5 million + $0.25 million
- Debt = $4.75 million
Debt-to-equity ratio is calculated using the formula given below
Debt-to-equity Ratio = Debt / Equity
- Debt-to-equity ratio = $4.75 million / $1.5 million
- Debt-to-equity ratio = 3.17x
Therefore, the company’s debt-to-equity ratio is 3.17x.
Types of Capital Structure
Companies either issue debt or equity to fund their business operations. Based on the mix of debt and equity, it can be broadly classified into three major categories – highly leveraged, lowly leveraged, and optimal.
- Highly leveraged: When companies increase their leverage through increased debt funding to improve profit margins. However, it creates the obligation to pay back lenders, which can aggravate the woes of a struggling business.
- Lowly leveraged: When companies issue more equity and give up some ownership in the company. In this way, they can fund business requirements and avoid the liability to pay back lenders.
- Optimal: Optimal capital structure is achieved when companies are able to pull off the perfect mix of debt and equity financing that results in maximum company value at the minimum cost of capital.
Factors
The factors that play a key role in the determination of a company are as follows:
- Cost of capital: It is the cost at which capital is raised from different fund sources. The interest rate is the cost of capital for a debt, while the rate of return is that for equity.
- Degree of control: The different types of shareholders and their voting rights influence a company’s capital structure. Typically, equity shareholders enjoy more rights than the preference shareholders or the debenture shareholders.
- Government policies: The rules and policies introduced by the government impact corporate decisions pertaining to capital structure.
Importance
It is a key factor in determining a company’s overall stability. Its importance can be ascertained based on the following:
- A company with a sound capital structure invariably enjoys a higher valuation in the investor community.
- An optimal capital structure ensures efficient use of the available funds, thus evading the issues of over or undercapitalization.
- Companies use appropriate capital structures to boost profits, which results in higher returns for shareholders.
Key Takeaways
Some of the key takeaways of the article are:
- A company’s capital structure indicates how it funds its overall business growth.
- A good capital structure control offers flexibility in terms of financing options and boosts shareholders’ returns by improving profitability.
- The debt-to-equity ratio is one of the most commonly used indicators of capital structure, and it is useful in determining the borrowing capacity of a company.
Conclusion
So, it can be seen that it is an important financial aspect of any company. It pertains to the decision about the proportion of debt or equity in the fund sources. A company that can achieve the optimal capital structure can maximize shareholders’ capital while minimizing the overall cost of the capital.
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