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How to Strike the Perfect Balance between Debt and Equity in the Capital Structure!

By January 12, 2022June 17th, 2024Blog8 min read
Investment Balance

The main goal of a company’s capital structure is to support business’ growth in a highly competitive environment. However, every company is different and has different funding needs. Enterprises need a sustainable capital structure to deliver returns to survive.

To thrive in this competitive world, you need to establish a sustainable capital structure to consolidate your company’s financial strength and achieve growth business.

The thumb rule of capital structure is to empower companies that are flexible enough to overcome any unforeseen economic storms that are likely to arise in the future. Thus, to maintain the ideal capital structure, every corporate financing company needs to establish an equilibrium between debt and equity.

Before moving ahead, we would like to inform you that maintaining the desired capital balance between debt and equity would be a daunting task.

By the end of the blog, you will be armed with the right strategies to help you strike the right balance between the two. Let’s get started.

Debt capital-

These are the funds borrowed by a company to finance business activities and should be repaid in a fixed period. This act of borrowing turns into long-term business loans or a short-term facility like overdraft protection.

Debt capital is different from equity or share capital as the investors in debt capital cannot become part owners of the business. Instead, they are called creditors, and the suppliers of debt capital receive a fixed annual percentage return on their loan known as the coupon rate.

It always ranks higher than equity capital for the repayment of annual returns. Thus, the interest on debt capital should be repaid fully before dividends are paid to the suppliers of equity.

We hope this might help you to make your decision.

Merits:

  • Lower financing cost
  • Maximise effect of financial leverage
  • Retain more profits within the company
  • Acquire allowable interest deductions

Demerits:

  • High interest rates
  • Effects your credit rating
  • Cash flow difficulties

Equity capital-

It refers to the capital paid by shareholders into a business and is raised in exchange for the share of ownership in the company, also known as equity shares.

These shareholders have considerable control over the company’s management. They tend to enjoy the rewards and bear the risk of ownership at the same time.

Meanwhile, their liability is just limited to the amount of their capital contributions, also known as equity financing.

The cost of equity becomes more complex as it takes the form of common stocks, preferred stocks and retained stocks. When you take a lot of equity, shareholders will dilute their overall ownership of the desired company. Make sure you go through the advantages and disadvantages of equity capital.

Merits:

  • Fixed costs unchanged by equity capital
  • Collateral-free financing
  • Long-term financing
  • Covenant-free financing

Demerits:

  • Investor expectations
  • Business form requirements
  • Financial returns distribution

Before you start with this, you need to understand how to pick the perfect debt-to-equity ratio to boost your balance sheet and bring in profits in the long-term. We have some strategies that may help you to balance debt and equity capital to run your business smoothly.

Top Strategies to acquire the Perfect Capital Balance

The debt-to-equity ratio is an essential metric for investors and banks willing to fund a firm. Different corporate finance companies have different ratios.

However, it wouldn’t be wrong to say that corporate companies have a maximum ratio of 1:2, wherein the equity capital is double than the debt capital.

Several financial professionals highly recommend this ratio, as a larger portion of equity guarantees that the organisation is efficient to cover any loss. When companies opt for higher equity, it means that returns are likely to drop eventually.

The level of debt can also lead to business risk. Too much debt can lead to bankruptcy while too little debt can prevent your business from expanding at a smooth pace.

These ratios tend to fluctuate dramatically throughout the lifetime of a company or as market conditions shift.

To maintain sustainable capital balance, companies should create funding methods to reduce their company’s weighted average cost of capital (WACC).

It is a calculation of a firm’s cost of capitalin which each category of capital is proportionately weighted. All sources of capital, including common & preferred stocks, bonds, and any other long-term debts, are included during the calculation.

You need to understand that any increase in WACC will gradually impact the company value and pose a risk to both lenders and investors.

Here, the organisation’s debt-to-equity ratio comes into the picture. Trying to maintain the ratio of 1:2 as a larger proportion of equity symbolises that the firm is sustainable in covering any losses.

Also remember: Companies with higher equity can weaken the shareholders and witness drop in returns.

The debt-to-equity ratios are likely to fluctuate throughout the lifetime of the company owing to frequent shifts in market conditions. Thus, there’s no thumb rule in terms of striking the perfect balance. All you need is to consider all the factors before any investments.

For instance:Flotation costs can make or break your decision-making process if your investor is charging large amounts to float shares. Here, issuing debt can be cheaper in the short-term. It’s the same with rising interest rates as companies have to offer large coupon bonds in exchange for high borrowing rates.

Also, high tax rates can possibly slash bondholder returns, making it difficult for companies with volatile earnings to guarantee sufficient cash to cover coupon payments. Even startups or younger companies can reduce excess claims on cash flow by choosing equity capital.

On the other hand, corporate finance companies should invest in research and development as many things related to capital balance rely on intensive research.

Every company should keep an eye on their competitors and conduct regular and thorough internal investigation along with stakeholders to generate forecasts, financing methods and create strategic plans to improve their business growth.

Along with this, you need to compare your company’s debt-to-equity ratio with others in the same sector. By doing so, you can compare your debt ratios with similar models to see where you stand. This will help you to adjust your debt ratio and find ways to keep your business competitive.

Disclaimer:High debts are too risky!

After understanding all these parameters, the best decision would be to increase debt levels if the interest rate is low and vice versa.

Try to have a flexible debt ratio to accommodate your business’ life cycle or seasonal changes. In case your business is seasonal, you have to borrow more frequently during the financial year. For a new company, you can borrow more to fund investments and payback when your business has matured.

Over to you!

For business debt, there’s nothing like a one-size-fits-all thing. The crucial thing is to understand the impact of debt and create a strategy that applies financial leverage prudently.

After reading this blog, you might have understood that creating a perfect capital balance is never a straightforward task. It’s like an ongoing responsibility that demands constant monitoring, adjustment and auditing.

As an entrepreneur, make sure you consider all possible parameters to establish the right balance between debt and equity. Till then, try not to lose your patience as you continually track your company’s ongoing cost of capital and market’s fluctuating gyrations.

Need help?

Rakesh Narula & Co. – a leading insurance surveyor & loss assessor firm in Vadodara, offering services like asset and liquidation valuation, technical due diligence, chartered engineering services and other consulting services. We are a leading valuation advisor with expertise in the areas of valuation of fixed and current assets for M&A, Bank lending, dispute resolution, insolvency, financial reporting, statutory compliances, corporate finance, etc. Contact us today!

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