Definition
The capital structure combines financial instruments like shares (equity and preference), debentures, long-term loans, bonds, and retained earnings. These instruments help the company generate funds for its operations with the help of individuals and institutions.
Factors affecting the Capital Structure
Several factors affect a company’s capital structure, and it also determines the composition of debt and equity portions within this structure. Some of these factors are as follows:
- Business Size – The size and scale of a business affect its ability to raise finance. Small-sized companies face difficulty in raising long-term borrowings. Creditors are hesitant to give them loans because of the scale of their business operations. Even if they do get these loans, they have to accept high-interest rates and stringent repayment conditions. It limits their ability to grow their business.
- Earnings – Firms with relatively stable revenues can afford a more significant amount of debt in their capital structure. Since debt repayment is periodical with fixed interest rates, businesses with higher income prospects can bear these fixed financial charges. On the other hand, companies that face higher fluctuations in their sales, like consumer goods, rely more on equity shares to finance their operations.
- Competition: If a company operates in a business environment with more competition, it should have more equity shares in its capital structure. Their earnings are prone to more fluctuation compared to businesses facing lesser competition.
- Stage of the life cycle: A business in the early stage of its life cycle is more susceptible to failure. In that case, they should use a more significant proportion of ordinary share capital to finance their operations. Debt comes with a fixed interest rate, and it is more suitable for companies with stable growth prospects.
- Creditworthiness: Any company that has a reputation for paying back its loans on time will be able to raise funds on less stringent terms and at lower interest rates. It allows them to pay back their loans on time. The opposite is true for firms that don’t have a good credit standing in the market.
- Risk Aptitude of the Management: The attitude of a company’s management also affects the proportion of debt and equity in the capital structure. Some managers prefer to follow a low-risk strategy and opt for equity shares to raise finances. Other managers are confident of the company’s ability to repay big loans, and they prefer to undertake a higher proportion of long term debt instruments.
- Control: A management that wants outside interference in its operations may not raise funds through equity shares. Equity shareholders have the right to appoint directors, and they also dilute the stake of owners in the company. Some companies may prefer debt instruments to raise funds. If the creditors get their instalments on loans and interest on time, they will not be able to interfere in the workings of the business. But if the company defaults on their credit, the creditors can remove the present management and take control of the business.
- State of Capital Market: The tendencies of investors and creditors determine whether a company uses more debt or equity to finance their operations. Sometimes a company wants to issue ordinary shares, but no one is willing to invest due to the high-risk nature of their business. In that case, the management has to raise funds from other sources like debt markets.
- Taxation Policy: The government’s monetary policies in terms of taxation on debt and equity instruments are also crucial. If a government levies more tax on gains from investing in the share market, investors may move out of equities. Similarly, if the interest rate on bonds and other long-term instruments is affected due to the government’s policy, it will also influence companies’ decisions.
- Cost of Capital: The cost of raising funds depends on the expected rate of return for the suppliers. This rate depends on the risk borne by investors. Ordinary shareholders face the maximum risk as they don’t get a fixed rate of dividend. They get paid after preference shareholders receive their dividends. The company has to pay interest on debentures under all circumstances. It attracts more investors to opt for debentures and bonds.
Conclusion
The proportion of debt and equity funds in a company is dependent on both internal and external forces. Businesses need to keep this in mind while deciding on the ratio of debt and equity instruments within their capital structure.
Frequently Asked Questions on Capital Structure
What is Capital Structure?
The capital structure combines financial instruments like shares (equity and preference), debentures, long-term loans, bonds, and retained earnings.
Which of these financial instruments is not a part of the Capital Structure?
1. Equity Shares
2. Preference Shares
3. Debentures
4. Short-term Borrowings
Short-Term Borrowings. It is a source of funds for the company that is a part of the Financial Structure.
Should a company opt for more debt or capital financing if operating in a non-competitive environment and why?
If a company operates in a business environment with zero or minimal competition, it should opt for a more significant proportion of debt financing in its capital structure. The reason is that they will be able to pay the fixed financial charges on debt, and the cost of capital will also be lower when compared to Equity instruments.
How does creditworthiness affect a firm’s ability to borrow capital?
A firm with a high level of creditworthiness can raise funds on less stringent terms and at lower interest rates. A good credit rating also allows them to pay back their loans on time. The opposite is true for firms with low creditworthiness in the market, and they will have to accept higher interest rates and more stringent repayment terms from their creditors.
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