Capital Structure in General
Every company needs capital to support its operations. Capital structure is a blend of various sources of finance. To be more specific, capital structure is a ratio of short-term and long-term liabilities with equity. Depending on the sources of financing, we can classify these as borrowed (or debt) capital and equity (owner’s) capital. Together, they form the company’s employed capital.
Companies with unstable income and operating cash flows should limit borrowed capital. On the other side, companies with more stable cash flows have more freedom to attract borrowed funds. But there’s still a question if borrowed funds are “better” than equity? If yes – should the company be fully funded by debt, or should it have equity in its capital structure? And what’s the optimal ratio of borrowed funds and equity?
- Capital Structure in General
- Factors affecting Decisions on Capital Structure
Read our detailed article Capital Structure and its Theories to know more about what is capital structure and what are its theories.
Let us answer these questions and briefly explain the factors affecting capital structure decisions.
Factors affecting Decisions on Capital Structure
Key factors affecting capital structure decisions are as follows:
Cost of Equity Capital
When the company decides to have more equity, it should keep in mind the cost of equity capital. There’s a common erroneous conclusion that equity is free of any cost. But that’s not true. Let’s not forget about dividends. If the owner is able to get, say, 40% of net income as dividends, the cost of equity can easily exceed the cost of borrowed capital. Business development is relied only on reinvesting profits into capital. It can reduce some financial risks but significantly decrease business growth speed. Attracting borrowed funds (given the right strategy) can significantly increase the owner’s income by introducing financial leverage. This is mostly true for small and medium companies, which often underuse the capacity of borrowing in their business.
Cost of Debt
Of course, debt is not free either. Interest and fees paid to lenders form the cost of capital. The less the cost, the more debt can be used. One advantage of debt is that interest paid is deductible to calculate income tax. Therefore, the more debt is used, the less is the company’s effective tax rate.
Issuing equity capital also isn’t possible without incurring additional floatation costs. These costs include various fees related to underwriting, brokerage, and receiving regulatory approval. Generally, the costs of issuing equity capital are more than that of issuing debt.
All goes well for the companies when the consumers receive their products well. 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 its capabilities too far.
It would be good for a company to rely on the owner’s capital during such a period. It reduces their obligation of making fixed payments. And, therefore, avoids a situation of bankruptcy. Hence, this determines that the borrowed capital had its own disadvantages too.
Change in Control
When equity is received not from existing shareholders (owners), problems of change in control can arise. Issuing new shares to the open market (i.e., in IPOs or FPOs) introduces new shareholders who can have a significantly different understanding of how the company should be run. And, if they have a large stake in the company, corporate conflicts can emerge. If the current owners want to have ultimate control over operations and lack additional funds, issuing equity to new shareholders can be inappropriate. Hence, debt is more suitable for financing in such cases.
Various regulatory frameworks often prescribe what proportion of equity a company should have in its capital structure. For example, banks are heavily regulated by central banks. Under the Basel III capital, the framework should have no less than 8% of its risk-weighted assets funded by equity capital and subordinated debt. Raising debt also usually imposes various debt covenants that restrict the proportion of debt a company is allowed to have.
Nature of Business and Risk
There is a risk in every business. However, risk differs from company to company, industry to industry, nature of product or service provided, etc. For instance, a company in the business of utilities will have fewer seasonal fluctuations than a company in the fashion industry. Therefore, a fashion retail company will usually focus more on the optimal debt ratio than a utility company. A lower debt asset ratio would make investors feel better about the company’s ability to meet responsibilities even in adverse situations.
Risk of Excessive Debt
When increasing the share of debt capital, the company should keep in mind rising risks. Analysts use several ratios to assess a company’s risks coming from debt capital. The interest coverage ratio (ICR) shows a company’s capacity to service its debt by paying interest and is calculated as EBIT to interest expense ratio. The higher is this ratio, the more proportion of debt the company can have. Owners and analysts should also consider that this ratio is not sufficient to conclude that the company actually has enough cash flows to pay interest.
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 structures. To know that, it is important to understand the company’s cash flow position, which can tell if the interest outstanding can be repaid? The debt service coverage ratio is calculated as net operating income to debt obligations (debt due in one year and interest) and is free from ICR’s limitations.
Capital Structure of Other Companies
No company exists in isolation from its industry and rivals, so the capital structure of other companies is also important. Companies in one industry produce almost similar products and use similar sources of funding and debt/equity mix. So when making decisions on the capital structure, it’s useful to take a look at debt/equity prevalent in a selected industry.
The capital structure of a business also depends on whether the management is conservative or aggressive. More aggressive management 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.
Stage of Business Lifecycle
A company goes through a number of stages in its lifecycle and to assess the company’s capital. It’s crucial to understand which stage it is in at the moment. Companies usually attract only equity capital when they start doing business because of a lack of collateral, and credit history gives few options to attract investors. But using borrowed funds helps to speed up business development significantly because accumulating profit is a lengthy process. Such an economy in time helps grow the company quicker and maximize profit.
In a period of crisis, companies usually develop business continuity plans, and the return on capital decreases. At this point, the company attracts more borrowed funds to fulfill its short-term obligations, and equity share in the capital structure shrinks (which evidenced a crisis in the company).
The company, overburdened with debt, looks less reliable for counterparties and investors; they can start looking for more attractive opportunities. On the other side, when the share of borrowed funds is too low, a cheaper funding source is not fully utilized, which leads to a decreased return on capital. The optimal decision on the capital structure will be the one with the lowest capital cost. One of the simplest implications of capital structure theory is the so-called traditional approach to capital structure.
To sum up, when reviewing factors affecting the capital structure decision of a firm, it’s important to remember that equity is characterized by the following:
- Simplicity in raising (no approval needed, only owner’s decision)
- A high rate of return on invested capital as interest on borrowed funds is not paid
- Low risk of losing solvency and therefore lower risk of bankruptcy
- Equity is limited, so it’s impossible to increase the business size significantly
- Leverage is not used, and the total return is less than possible
Borrowed funds (debt) have the following advantages and disadvantages:
- The vast amount of capital to be raised (given appropriate collateral or guarantee)
- Possibility to develop business fast
- Can improve return on capital
- Harder to attract because lenders seek their own optimal risk-return ratio
- Lower company’s solvency