Capital Structure, as the name suggests, means arranging capital from various sources, in order, to meet the need of long-term funds for the business. It is the combination of equities, preference share capital, long-term loans, debentures, retained earnings along with various other long-term sources of funds. We can say that capital structure refers to the proportion of each of these sources of funds in the capital, which the company should raise or arrange to carry its business effectively. Thus, capital structure is extremely important and capital structure decisions or practices have a significant role to play in corporate financial management.
Also, capital structure decisions impact the risk and return of equity owners. Owing to such importance, the management needs to take an informed decision of having a perfect capital mix.
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Ideal Capital Structure
A balanced capital structure is important for the overall health of the company. Excessive use of any component in the capital mix might not work in favor of the company. For instance, a company cannot excessively rely on the debt because it is more expensive for the company compared to the equity. An ideal capital structure should help the company to;
- Minimize the cost of capital
- Reduce business-related risks
- Provide needed flexibility
- Provide control to the owners
- Maximize the value of the firm
Factors Affecting Capital Structure Decisions
There are various factors that management must consider while making capital structure decisions. These factors are:
All goes well for the companies when their product is received well by the consumers. Problems come during a downturn. Even during the slowdown, the firm needs to run, and thus, needs capital. But it becomes very difficult for a company to raise capital in bad times. Therefore, irrespective of the booming business and economy, the business should always discount for the bad times and do not stretch the capabilities too far.
A company with low debt in the mix would be better off in bad times. One of the most common mistakes that companies do is raising capital through debt without analyzing their ability to repay those. As a result, they fail to service the debt in bad times, thus losing the confidence of the investors.
Usually, debt payments are tax-deductible and result in tax benefits. This is why companies prefer having some amount of debt in their capital structure.
There is a risk in every business. However, risk differs from company to company, industry to industry, nature of product or service provided and so on. For instance, a company that is into the business of utilities will have less seasonal fluctuations compared to the company in the fashion industry. Therefore, a fashion retail company will usually be more focused on the optimal debt ratio compared to the utility company. Lower debt asset ratio would make investors feel better about the company’s ability to meet responsibilities even in adverse situations.
Nature of Industry
The nature of the industry plays a very important role in defining the capital structure. For instance, in an industry where there is no barrier to the competition, the profit margin of existing firms will be more at risk. Therefore, the firms will be hesitant to use a fixed charge bearing securities.
Operating Cash Flow
Capital structure to some extent is also impacted by the fixed cost. If a company uses a very high proportion of fixed cost in the total cost, it can amplify the variability in future earnings. If the operating leverage is high, there are more chances of a business failure, and the company could even go to the extent of bankruptcy. Therefore, management should take a balanced approach to get a perfect mix of capital structure.
The capital structure of a business also depends on whether the management is conservative or aggressive. A management that is more aggressive would not be afraid of taking a risk, and therefore, more debt will definitely not be an issue. On the other hand, conservative management would prefer a lower risk even if it means comparatively lower returns.
Apart from these factors, there are various other elements that affect the capital structure decisions of an organization. Management takes into account various ratios such as debt service coverage ratio, interest coverage ratio and more. Cost of debt and return on investments are a few more factors that a company considers while making capital structure decisions.
Tips to Getting Capital Structure Decisions Right
Along with the above factors, there are a few tips that can help management take better capital structure decisions;
- Management must evaluate the company’s needs for capital. Usually, a company needs capital for four things – Operations, Organic growth, Acquisitions and Returning cash to shareholders. Management must determine the minimum liquidity that it will need to finance these four things.
- Should prepare liquidity level on the basis of “what if” scenarios. For instance, preparing capital structure if there is a 20% to 30% drop in the business activity.
- Determine if the company’s credit rating is good enough to guarantee instant access to funds. If the rating is not good, the company will then have to make adequate adjustments in the capital structure.
- Develop a clearly defined decision-making framework. This will guide the management when dealing with different liquidity scenarios. Having a framework also means that capital structure decisions are not just an instant reaction to a change in the condition. Instead, the decisions are based on the carefully thought framework.1,2