Capital structure is a term used in finance. It is the percentage of capital/money at work in any type of business. It is the composition of long term and specific short term liabilities (bank notes), common equity, and preferred equity which funds the business for its operations and growth. A business’s capital structure is the right side of balance sheet. It explains how the business organization finances its assets. It combines various resources of senior debts, mezzanine debt and equity. The term further describes the proportion of capital available with the company or the operating money. This money is obtained through debt versus the proportion obtained through equity. It is also the ration of different securities which are raised by the company as its long term finance. It is the outstanding debt and equity of the company which allows understanding what sort of financial resources are used by the company to fund its overall operations. Capital structure thus shows the proportion of senior, subordinate debt and equity in the funding. The mail purpose is to analyze the risk level of the company. It is commonly known as debt – to – equity ratio.
Capital structure is a framework of various types of financial modes which are employed by the company to acquire the required resources to fund its operations and growth. It is comprised of investments by stockholders which are equity capital and the long term loans which are loan capital. It doesn’t include the short – term longs for example overdraft and liabilities like trade credit. The capital structure of any company is composition of its liabilities. There exists two forms of capitals i.e. equity capital and debt capital. These both have their own drawbacks and benefits. So, the corporate management always attempts to find perfect capital structure.
Equity Capital: It is considered to be most expensive capital which a company can use. This type of capital is the money which is put up and is owned by the shareholders. It consists of two types which are contributed capital and retained earnings. Contributed capital is the money which was invested originally in the business in the exchange for shares of stocks. Retained earnings are the profits which the company has kept from the past years. These are used in order to provide firm strength to the balance sheet or the fund growth, acquisitions or the expansion.
Debt Capital: This capital is the borrowed money which is at work. It can include short term commercial paper. These are utilized by giants businesses such as Wal – Mart and General Electric. These business companies alone accounts billion dollars in 24 hours loans from the capital markets in order to meet day to day working capital requirements. These capital requirements can be anything be from payroll to utility bills. The cost is dependent on the heath of the balance sheet.
Factor Determinants of Capital Structure:
- Trading on Equity: Equity is the ownership so trading on equity is the advantage of equity share capital to borrowed funds on reasonable basis. If the shareholders’ expectations are high, trading on equity becomes quite important.
- Degree of Control: The directors of the company are the elected representative of equity shareholders. They have got maximum vote as compared to shareholders and debenture holders.
- Financial Plan Flexibility: The financial plans for capital structure should involve contractions as well as relaxation. The company should go for issue of debentures and other loans if it wants to make capital structure.
- Investors Choice: Every company needs different categories of investors for securities. So the capital structure of the company should involve all investors for investment.
- Conditions of Capital Market: The market price of share puts an important on the company. The capital structure generally involves debentures and loans during depression and during recession or inflation; it should consist of equity shares.
- Financing Period: For short term financial needs, the company takes loans from financial institutions such as banks. For long term financial requirements, the company issues shares and debentures.
- Cost of financing: When the securities are raised, the company should look the cost factor. As compared to equity shares where an extra share in profit is demanded by the shareholders, the debentures prove to be cheaper financial source for the at the time of profit earning.
While analyzing the capital structure, the short term and long term debt is taken under consideration. When we talk about capital structure, the very first intention goes is about the debt/equity ratio. This ratio insights the risk level of the company. If a company has high rate of finance debts, it has greater risks due to highly being leveraged. So, the small business owners should identify and determine a well targeted capital structure as it is very expensive for them. The decisions of capital structure are complex due to many factors involved. Capital structure generally involves the following decisions:
Types of the securities which are to be issued include equity and preference shares and long term borrowings. Long term borrowings are debentures.
Capital gearing can determine the relative ratio of securities. On the basis of capital gearing the companies are categorized as highly geared and low geared. High geared companies are those whose proportion of equity capitalization is small. Low geared companies are those where the total capitalization is dominated by equity capital.
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