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Business Structure refers to the level of operations and set up of an organization. The structure generally defines the financial position of the business. It reflects the cash flow of the company. Every business has a different combination of finances depending upon the needs and level of operations. Each company or business has a separate and unique debt-equity ratio.
There are two types of structures: Capital structure and financial structure. These two structures reflect the assets and liabilities position of a firm in its balance sheet.
Assets= Liabilities + Equities
Let’s understand these two terms in detail:
Financial Structure: It is reflected in the Liability side of the balance sheet. It balances the company’s equities and liabilities.
Capital structure: It is known as the mixture of long term funds like debts or share capital including the profits. It is a part of the financial structure. It becomes financial structure when the short term liabilities are added into it. Hence, we can say that the capital structure is that part of financial structure which defines the long term sources of finance. It is reflected in the Assets side of the balance sheet.
Factors determining financial structure:
Finance is the most important requirement of a firm to run its business. Hence, it is required at all the levels and the decisions regarding the financial structure are to be taken on a regular basis. Various factors must be considered while taking decisions regarding the financial structure like:
- Leverage or Trading on equity: It is very important to consider the financial leverage while planning the financial structure as it directly affects the value of earning per share. The use of fixed financial sources like debts or preference shares to run the business is known as trading on equity. It could have a different effect on different firm, depending up on their debt capital. The intensity of trading on equity can be calculated with the help of debt-equity ratio.
- Cost of capital: It refers to the minimum expected amount or return from various sources. The expected returns depend upon the intensity of risk factor. In order to keep the cost of capital minimum, alternative capital sources must be compared. It includes the interest, payable dividend, and the amount used while raising the finances from different sources like the legal expense, promotional costs, travelling costs, fee or commission to any agent etc.
- Cash flow position of the company: It is very important to examine the cash flow of the company while planning the capital structure. At the time of raising additional finances, it is important to analyze the future cash flow which could meet the fixed charges. The fixed charges include the payment of dividend, interest and other preference charges.
- Maximum control: Some capital or securities have the voting rights which enable them to control the operations of a business. At the time of raising the additional finance, it is important to maintain a balance between the voting (equity capital) and non-voting capital (debentures, loans etc.). The balance is required to maintain the proper control in the business. The ideal ratio of voting and nonvoting securities has never been determined.
- Flexibility: It is the most important requirement of a business. The business environment is dynamic in nature. It is always changing. The business operations depend upon the external environment. Hence, to survive in the market, it is important to be flexible and change according to the environmental changes. The capital structure must be flexible in terms of combination of finances. The capital flexibility depends upon the various factors like service charges, debt capacity, policies of loan, legal regulations etc.
- Size: It is the least important factor affecting the capital structure of an organization. Small scale firms do not attract investors, whereas larger scale organizations always get the investors whenever they need additional capital.
Factors to be considered in the capital decision making process
There are various factors which need to be considered while establishing the company’s capital structure. The quality and quantity must also be considered. The capital structure decisions are considered by analyzing the internal and external factors.
From the point of view of sales: The company, which has better sales is in a better position to use financial leverage in comparison to another company having low sales volume.
In view of risk: Company with less operating leverage is able to take on more financial leverage.
Third, in terms of growth: Companies which have faster growth rate are able to rely more on financial leverage because such companies need more capital.
Fourth, taxes: The Company having a higher tax bracket utilizes the debts more which provides ax benefits.
Fifth, less profit earning companies use more financial leverage, when the company cannot use or do not have its finance to operate.
The company uses leverage to raise its earnings and return on equity. Along with these benefits, the chances of high earning variable cost of financial distress and the bankruptcy also increases. While considering these factors, the management should consider the tax rates, risk factor, flexibility, managerial effectiveness etc. while deciding the maximum capital structure.
The company’s capital structure defines the financial position of the company. It plays a very important role in deciding the perfect capital structure.