Capital Structure

Introduction 

Capital is the money that is required for business day-to-day operation and future growth. There are mainly four types of shareholder's capital includes common stock, preferred stocks, debt capital (bonds and debentures) and retained earnings. 

The capital structure is the mixture of owned capital and borrowed capital. The owned capital includes equity, reserves and surplus while borrowed capital includes debentures or bond and loan. It is also known as the mixture of equity and debt capital. It can be expressed as:

Capital Structure = Total Equity + Total Debts

Where, 

  • Total Equity = Internal Equity or Common Stock +Preference Stock+External Equity or Retained Earnings (Reserves and Surplus)

  • Total Debts = Long-term Debts + Short-Term Debts

 


Note 1: Financial structure is the representation of total debts. It can be expressed as: Financial Structure = Total Debts

Note 2: Long-term debts are those debts that can be paid after one years such as bond, debentures, term-loan etc.

Note 3: Short-term debts are those debts that is paid within a year such as notes payable, bills payable, accounts payable, tax payable etc.

Types of Capital Structures

Basically there are three types of capital structures described as bellows:

  1. Equity Structure: It is the combination of all the equity sources of capitals such as common stocks, preference stocks, retained earnings, etc.

  2. Debt Structure: It is the combination of all debts sources of capitals such as bonds, debentures, loans, etc.

  3. Hybrid Structure: It is the combination of both equity and debt capital structure.

Advantages and Disadvantages of Equity Structure or Financing

The following are advantages that can be seen for equity structure listed as below:

  • Advantages of Equity Structure

    • Risk and return aligned with company's performance 

    • No loan to repay

    • Less stress or burden

    • No credit history is required

    • Opportunity to learn and grow

  • Disadvantages of Equity Structure

    • Share Profit

    • Loss of Control

    • Potential Conflict

Advantages and Disadvantages of Debt Structure or Financing

The following are advantages that can be seen for debt structure listed as below:

  • Advantages of Debt Structure

    • Controlling Power

    • Tax Advantages

    • Easier Planning

  • Disadvantages of Debt Structure

    • Collateral Requirement

    • Discipline

    • Knowledge requirement

Risk Conditions at Capital Structure

The condition of risk for determining the capital structure may vary from two points of view:

  1. From Investor Point of View: The investors always wants to see less debts in the company's capital structure to ensure that there is low risk for investment.

  2. From Company Point of View: The company always wants to see high debts in the company's capital structure to save more profit due to more interest expenses and low tax amount.

Factors Affecting Capital Structure

Capital structure is more important to maintain overall stability in the company. There are some major factors that can affect the capital structure listed as bellows:

  • Cost of Capital: It is the cost of funds that a company always wants to keep as much as low to save more profit.

  • Degree of Control: The company determines its capital structure based on optimum level of shareholders to limit voting.

  • Trading on Equity: It is occur when rate of return of equity is more than rate of interest of debts. 

  • Government Policy: The capital structure is determined based on government policy that includes both monetary and fiscal policy of the country.

Optimum Capital Structures

Basically, there are two levels of optimum capital structure explained as bellows:

  1. Current Optimum Capital Structure: It is the mix of debts and equity capital that results to minimum WACC (weighted average cost of capital) at present state. 

  2. Targeted Optimum Capital Structure: It is the mix of debts and equity capital that results to minimum WACC (weighted average cost of capital) that any company plans to raise.

Optimum Capital Structure By Industry

The optimum capital structure may vary from industry to industry or company to company. The following are the list of some industry or company and their capital structure as bellows:

 Table: Capital Structure by Industry

Total Asset of the Company

The total asset is the sum of total equity and total debts funds. The percentage of total debt or equity lies between 0% to 100%. So, based on this range, there are five possible optimum capital structures that come for applying in the company’s financial policy.


Fig: Total Assets of Company

  1. There are 100% Debt in the company

  2. There are 25% Debts in the company

  3. There are 50% Debts in the company

  4. There are 75% Debts in the company

  5. There are 100% Equity in the company

Ratio Applied to Capital Structure

In broad sense, the company uses three ratios to measure the strength of the company’s capital structure.


Fig: Ratios related to Capital Structure

  • Debt Ratio: It measures leverage position of the company by the total debts to total assets.

  • Debt-to-Equity Ratio: It measures the financial liability against shareholder's equity

  • Capitalization Ratio: It compares total debts position over total capital structure.

These ratios indicate the leverage position in the company. Leverage ratio refers to the proportion of debt compared to equity capital.

 Conclusion

The capital structure is the mixture of owned capital and borrowed capital. It is also known as the mixture of equity and debt capital. Financial structure is the representation of total debts. Basically, there are two types of capital structure; Targeted Capital Structure and Optimum Capital Structure. The condition of risk for determining the capital structure may vary from two points; one is from investor point of view and from company point of view. Basically there are three types of capital structures include equity structure, debt structure and hybrid structure. The Capital structure may vary from industry to industry or company to company. The total asset is the sum of total equity and total debts funds. The company uses three ratios to measure the strength of the company’s capital structure include debt ratio, debt-to-equity ratio and capitalization ratio.

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