Question

What is meant by 'Capital Structure' of a company?

State any two factors which affect the capital structure of a company.

Answer 1

Capital structure means the proportion of debt and equity used for financing the operations of business.

Capital structure = Debt / Equity

In other words, capital structure represents the proportion of debt capital and equity capital in the capital structure. What kind of capital structure is best for a firm is very difficult to define. The capital structure should be such which increases the value of equity share or maximizes the wealth of equity shareholders.

Factors Determining the Capital Structure:

The various factors which influence the decision of capital structure are:

1. Cash Flow Position:

The decision related to composition of capital structure also depends upon the ability of business to generate enough cash flow.

The company is under legal obligation to pay a fixed rate of interest to debenture holders, dividend to preference shares and principal and interest amount for loan. Sometimes company makes sufficient profit but it is not able to generate cash inflow for making payments.

The expected cash flow must match with the obligation of making payments because if company fails to make fixed payment it may face insolvency. Before including the debt in capital structure company must analyse properly the liquidity of its working capital.

A company employs more of debt securities in its capital structure if company is sure of generating enough cash inflow whereas if there is shortage of cash then it must employ more of equity in its capital structure as there is no liability of company to pay its equity shareholders.

2. Interest Coverage Ratio (ICR):

It refers to number of time companies earnings before interest and taxes (EBIT) cover the interest payment obligation.

ICR= EBIT/ Interest

High ICR means companies can have more of borrowed fund securities whereas lower ICR means less borrowed fund securities.