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An Overview on Capital Structure: A backbone to the Business

By January 11, 2022June 30th, 2022Blog5 min read
Financial Growth

The capital structure is the appropriate combination of debt and equity utilized by a company to finance its overall operations and growth.

Capital structure implies the arrangement of capital from distinct sources so that long-term funds required for the business are raised. It encompasses the combination of equities, preference share capital, long-term loans, debentures, retained earnings, and other long-term sources of fund.

Debt consists of bond issues or loans, whereas equity consists of equity and preference shares or retained earnings. Debt is the borrowed money that is due back to the leader while equity is owner’s fund itself, without the need to pay back any investment.

The capital structure allows analysts to identify the optimal value of the cost of capital of a company. This makes the capital structure very significant with decisions in corporate finance.

IDEAL CAPITAL STRUCTURE

  • Provide financial flexibility
  • Minimise the cost of capital
  • Reduce business-related risks
  • Provide control to the owners
  • Maximise the value of the firm

TIPS FOR RIGHT CAPITAL STRUCTURE DECISIONS

  1. Management must determine the needs of the company for capital. Mostly, a company requires capital for four essentials – Operation of the company, Organic growth, Acquisitions and Returning cash to shareholders. The management has to determine minimum liquidity that will be required to finance these four things.
  2. Calculate if the company’s credit rating is good enough to undertake instant access to funds. If the score is not satisfactory, then the company will have to make adequate adjustments in the capital structure.
  3. Create liquidity level on the basis of “what if” scenarios. For example, preparing capital structure if there is a 20%-30% decrease in business activity.
  4. Create a clear decision-making framework. A framework also implies that capital structure decisions aren’t just a reactionreaction to change in a condition. In fact, the choices are based on a thoughtful framework.

Read the blog to get an overview of corporate finance: https://www.rakeshnarula.com/blog/corporate-finance-is-called-lifeblood-of-business/

IMPORTANCE OF CAPITAL STRUCTURE

    Utilisation of available funds

A good capital structure allows a business enterprise to utilise the available funds fully. A well-designed capital structure evaluates well-versed financial requirements of the firm. A sound capital structure preserves business from over-capitalisation and under-capitalisation.

    Increase in the firm’s value

Capital structure enhances the market value of a firm, i.e. a firm has an appropriately designed capital structure. The aggregate amount of the claims and ownership interests of the shareholders are maximised.

    Maximisation of return

An appropriate capital structure ensures management to raise the profits of a business enterprise in the form of greater return to the equity shareholders, i.e. increase in earnings per share. This can be accomplished by the mechanism of trading on equity which refers to a rise in the amount of debt capital in the capital structure, leading to being the cheapest and feasible source of capital.

    Financial flexibility

A good capital structure offers a room of expansion or reduction of debt capital. Hence, according to varied conditions, adjustment of capital can be made. Despite the slowdown, the company needs to run and thus requires capital. But it becomes very challenging for a company to raise capital in difficult times. A firm with low debt in the financial mix strategy would work better in a financial slowdown. One of the major errors that firms make is raising capital through debt without analysing their ability to repay them. Ultimately, they fail to service the debts in challenging times, thus losing the confidence of the investors.

    Minimisation of cost of capital

Minimising the overall cost of capital is indirectly proportional to capital structure i.e. maximises shareholder’s wealth leading to a sound capital structure for any business enterprise.

    Solvency or liquidity position

A balanced capital structure would avoid raising too much of debt capital because, at the time of poor earning, the solvency is shaken for compulsory payment of interest to the debt supplier.

    Minimisation of financial risks

With the increase in the debt component, the financial risk also increases. A good capital structure protects a business firm from such financial threats through a qualitative balance of debt and equity in the capital structure.

FINAL THOUGHTS!

Capital structure is a significant part of corporate financewhich maximises shareholder’s wealth and minimises the cost of capital. A sound capital structure the backbone of a business enterprise, focusing on value creation which turns out to be fruitful. Getting guidance from a finance professional will make the path easier and understandable for businesses, and the owners will have an idea about where, how and how much to invest.

Rakesh Narula & Co. offers services like asset and liquidation valuation, technical due diligence, chartered engineering services, consulting services, investment banking, corporate financing and more.

Our professionals will guide you in making financial decisions for your business, ensuring that your company functions smoothly, sustaining their position in the market. We also have the much-needed experience to handle claims for property, process and engineering industries towards material loss as well as loss suffered due to business interruption. Contact us to know more!

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