A company can finance its activities through either equity finance or debt finance or both. The combination of equity finance and long-term debt finance that a company uses is known as its capital structure.
Equity finance can include instruments such as share capital, preference share capital, retained earnings, etc. while debt finance can include loans, debentures, public deposits, etc.
The capital structure of a company can be mathematically written as:
Capital structure = Equity + Long-term debts
By assessing the capital structure of a company, investors can assess the strength of a company’s balance sheet. Furthermore, the capital structure of a company can be used to calculate the ratios such as the gearing ratio, also known as the leverage ratio, which is one of the key indicators of a company’s position.
There’s no ideal proportion of equity and debt for a company. Some companies are heavily reliant on equity finance to fund their activities while some rely more on debt finance. Debt finance is cheaper for companies as it avoids the dilution of ownership of a company and can result in tax savings. However, investors prefer not to invest in companies with a high proportion of debt as the investment is deemed risky.
When investors consider the capital structure of a company, they should not look for any ideal numbers or percentages.
Instead, they can compare the capital structure of the company with its competitors and the industry average to determine whether the stock is attractive. Investors prefer a capital structure that provides them with the best returns or maximizes the value of their equity stockholding.
The capital structure of a company can affect its earnings and financial risk and therefore, it is important for a company to manage it properly. Companies use the gearing ratio to determine the optimal capital structure to benefit the equity stockholders, however, there are some factors that determine the capital structure of a company.
Importance of Capital Structure:
It is important for companies to have a balanced capital structure for the following reasons:
- Makes company stock attractive for investors: As mentioned, when investors look into companies to invest in, they prefer companies with a sound and balanced capital structure. This means that if a company has a balanced capital structure, investors will be willing to invest in the company’s stock more. This will also increase the value of the company’s stock in the market.
- Better cash flows: A proper capital structure helps a company manage its cashflows better. This helps companies make decisions on when they need funds and which sources they can utilize for the funds. In addition, it helps companies ensure they are not over-capitalized or under-capitalized.
- Increases earnings and returns: By properly managing their capital structure, companies can ensure they are generating the maximum possible value for their stockholders. This, in the term, makes the stocks more attractive to potential investors.
- Reduces financial risk: As previously mentioned, debt finance is deemed risky for companies. By proper management of the capital structure, companies can ensure the risk is reduced to a minimum level.
- Helps with tax planning: A company can find the proper mix of capital structures for effective tax planning. For example, a company can take benefit of tax deductions provided by debt finance which is not allowed for equity finance.
- Minimizes the cost of capital: A proper capital structure helps the business minimize its cost of capital. This can be done through a proper mix of long-term debt and equity finance.
- Factors Affecting Capital Structure: Companies always want to have a sound capital structure to attract investors, however, this might not always be possible. The decision regarding the company’s capital structure can be affected by certain factors, as follows:
- Dilution of control: While a company might want to decrease its debt finance to a minimum due to the risks associated with it, it still needs to consider the dilution of control that comes with equity finance. Furthermore, a company cannot raise all its finance through equity as the cost of equity is higher for a company than the cost of debt.
- Gearing (Leverage) ratio: The gearing ratio of a company is the ratio of its debt to its equity. As mentioned above, investors use the gearing ratio of a company to determine the feasibility of their investments. A high gearing ratio means the investment is riskier for the investors.
- Legal requirements: Sometimes there might be some rules and regulations that govern the capital structure of a company. For example, if a company takes a loan from a bank, the bank may bind the company to always have a certain level of equity.
- Nature and size of a company: The capital structure of a company will also be dependent on its nature and size. For example, a company with seasonal nature or one with slow cashflows will opt not to finance its operation with debt finance as it may not be able to pay it back on time. Likewise, small companies may not meet the necessary requirements to qualify for a loan.
- Cost of capital: Companies will generally prefer funds with a low cost of capital. This will ensure that the company is generating the maximum level of wealth possible for its stockholders.
- Floatation cost: Raising finance through equity has costs associated with it. These include costs such as registration fees, legal fees, underwriting fees, etc. In comparison to these costs, raising debt finance has lower costs. This may discourage some companies to raise finance through equity finance.
- Capital market conditions: A company may want to take advantage of a bull market. When the prices of commodities in a market start raising, it is known as a bull market. In these circumstances, companies may want to take advantage of the rising prices and raise equity finance. The opposite of the bull market is the bear market. Companies may want to avoid issuing shares in a bear market.
- Cashflows: A company must consider its cashflows as well when deciding on its capital structure. For example, if a company wants cash quickly, it must consider whether debt finance or equity finance is easier to obtain at the given time. For debt finance, companies should also consider when the time comes to repay the debt, it has enough cashflows to not only meet the repayment obligation but also to cover the void in cash reserves caused by the debt repayment.
- Flexibility: A company would want its capital structure to be flexible. As times change, the company should be able to change its capital structures with market demand. For example, if the government announces a decrease in tax deductions allowed for debt finance, companies might want to reconsider their capital structure.
- Investors’ preferences: Companies also consider the preferences of their existing investors and any potential investors. Some investors prefer to take more risks and will, therefore, have no problem with a debt-dominant capital structure while some may not prefer to take risks and oppose the idea.
The capital structure of a company is important for both the company itself and any potential investors.
Managing the capital structure can reap a lot of benefits for a company in both monetary and non-monetary terms. However, there are some factors that might play a role in deciding the capital structure of the company.