What is capital structure and why is it important?

What is Capital Structure? 

The basic and the foremost thing required to start a business is the “money” i.e., Capital. For any working in business, the basic requirement is money. Let’s say, an organization needs Rs. 1 crore to start a business. Does this mean that the promoters have to infuse the entire Rs 1 crores? Well, it depends on the capital structure of the organization. Now, what does this capital structure mean? Capital structure is the source of funds through which the capital is introduced. It includes Debt Capital, Public Equity, Preferred Stock, Bank loans, etc. In the other words, so according to chartered accountant services providing companies or experts having an optimal Capital Structure is very important for the organization.

Technically, Capital Structure means a composition of the funds of a corporate entity, which includes capital contributed by the owner, capital that has been procured through a loan, or any other form of capital infusion which helps the entity to smoothly run the operations over the period of time. In other words, the Capital structure can be termed as a method by which the finances for a company are managed.

Types of Capital Structure:

Primarily, Capital Structure consists of broadly two types:

• Equity Capital
• Debt Capital

Equity Capital:

This is the basic form of capital that reflects the amount contributed by the owners or promoters of the Company. They are the ones who run the business of the Company. The equity holders or the owners of the Company have significant control over its management.

Shares are issued to them in return for the capital invested by them and further, they enjoy the rewards and bear the risk of ownership. However, their liability is limited to the number of their capital contributions.

As a return on equity, that gets the profit of the Company left out after meeting all expenses including interests on debt, taxes. Etc.

The part of the profit that is being paid to them is called the “Cost of Equity” of the Organization. This type of Capital is quite risky from an investor point of view, as shareholder gets a return on shares only if any left or even nothing, in case of losses incurred by the Company.

On the other hand, from the organization’s point of view, it will be more relaxing as there is no liability to pay any amount to equity shareholders in case of loss or no profit, but in return, the organization has to give its control to Equity shareholders.

Further Equity Capital consists of two types:

• Retained Earnings
• Capital Contributed

Retained Earnings: Retained Earnings are that part of the profit earned by the Company and that remained undistributed to shareholders and retained in the business for the future.

Capital Contributed: Capital contributed is the original or initial amount of money invested by the owners in the business in exchange for the shares or stocks of the Company.

Debt Capital:

Debt represents the amount borrowed by the Company from outsiders. These people are concerned only with the returns on the amount invested. Debt providers will not participate in any decision-making process of the Company. As they are not the owners of the Company.

They are just providers of finance. The debt providers will get a return in the form of interest. The interest that is being paid to them is called the “Cost of Debt” of the Organization. Interest payable to debt holders is the committed cost for a business.

So, the cost of debt is the minimum return that the business should earn so as to serve the interest cost. The Company can get debt capital through different modes. Some of them are Debentures, Bank loans, Bonds, etc.

This type of Capital is less risky from an investor’s point of view, as the debt provider gets to return in the form of Interest, irrespective of the amount of profit earned by the Company. On the other hand, from an organization’s point of view, it will be more obligatory as Organization has to pay interest even if there is loss or no profit, but in return organization not required to give its control to Debt providers.

• Long term debt
• Short term debt

Long-term Debt: These types of debts are considered the safest form of debt as they have an extended repayment period, and only interest needs to be repaid while the principal needs to be paid at maturity.

Short-term Debt: These types of debts are used by companies to raise capital for a short period of time.

Role of Capital Structure:

Having an Optimal Capital Structure in the Organization is considered the key to success. However, it is very difficult to choose the optimal capital structure. Optimal Capital Structure is basically the perfect mix of debt and equity in the capital of the organization. Having a perfect balance of debt and equity is something known as “Optimal Capital Structure”. The perfect mix is the balance between both that helps in maximizing the value of a company in the market while at the same time minimizes its cost of capital.

There is no exact proposition of debt and equity that can be termed as a perfect mix or optimal capital structure. The proposition of debt and equity that an organization must have depends on various factors. Will discuss it in a later part of this article. Traditionally, people believe in having debt-free businesses but now both are important and need to be mixed.

Debts are burdensome on Company and require consistent liquidity to pay interest which seems to be difficult in the initial stages of business. It doesn’t mean we prefer equity capital only as Equity holders have control over the Organization, which after some extent becomes a problem. Even investing the whole amount on its own initially becomes difficult in some cases where a large capital base is required. But, rather we can say that raising money as debt capital is preferable as organizations can get debt only if they have a strong equity base.

Too much of anything can be harmful in many ways. Similarly, a Company should raise debt capital, sufficient enough to run the operations of the Company or for a short-term purpose. Excess infusion of capital with a commitment to pay fixed interest does not make sense.

Why consider Debt Capital?

Debt allows companies to leverage existing funds, thereby enabling more rapid expansion than would otherwise be possible. The effective use of debt financing results in an increase in revenue that exceeds the expense of interest payments. In addition, interest payments are tax-deductible, reducing a company’s overall tax burden.

Why consider Equity Capital?

Equity Capital stimulates growth without requiring repayment, shareholders are granted limited ownership rights. They also expect a return on their investment in the form of dividends, which are only paid if the company turns a profit. A business founded by shareholder equity is beholden to its investors and must remain consistently profitable in order to fulfill this obligation.

Example of Capital Structure

The capital structure of the entity over the projected years is as follows:

S. No.	Year Ending On	March-21	March-22	March-23	March-24	March-25
A	Shareholder’s Equity	1,764	3,243	5,371	8,255	11,522
B	Total Capital Employed	3,445	4,892	6,894	9,589	12,667
C	Equity Ratio (A/B)	0.51	0.66	0.78	0.86	0.91
D	Total Outside Long term Liabilities	1,680	1,649	1,523	1,334	1,145
E	Debt Ratio (D/B)	0.49	0.34	0.22	0.14	0.09
F	Debt Equity Ratio (D/A)	0.95	0.51	0.28	0.16	0.10

Explanation:

• Ratios play a wide role in the financial evaluation of a Company. Companies with consistent and stronger ratios are always rewarded by the market.
• As one can observe in the graph above, the decreasing trend of the debt-equity ratio depicts the consistent and regular repayment of the principal of the debt taken by the Company. This builds a stronger base for the Company in terms of credibility.
• The falling debt-equity ratio implies the increased profits (after tax) of the Company, increased cash flows of the company, and consistency of repayment towards the debt capital over the period of time. On the other hand, any zig-zag movement in the graph above should mean inconsistency in profits or repayment of debt capital. Volatile movements in the above graph represent the inconsistent cash flows of the Company.

Factors Affecting Capital Structure:

The capital Structure of the Organization depends on various factors. Some of them are:

Liquidity: Companies that have a stable stream of cash flows can afford to take debt. This is because debt capital is often redeemable and needs to be repaid on the date of maturity. Also, the interest cost of debt capital needs to be served regularly. This is not possible for a company with irregular cash flows.

Stability: Regular stream of cash flows is connected with the stability of sales. A stable range of sales increases the ability of the Company to serve the interest. Thus, in case of a company facing from decreasing trend of sales, it is advised not to infuse an additional amount of debt.

Degree of Control: Increase in debt capital leads to dilution of equity shareholders. This increases the risk for the promoters of the Company. The promoters need to ensure that at all points of time, the control is retained by the equity shareholders.

Flexibility: The capital structure of a company should be flexible enough such that the debt amount can be expanded at the time of need. This saves the company from the demerits of overcapitalization. Thus, a tradeoff between the need for funds and the availability of debt needs to be maintained.

Cost of Issue: Issue of new capital leads to an increase in floatation cost. Companies with lower credit ratings need to incur higher levels of floating costs.

Term of Capital: Capital structure is linked with the period through which the funds are required by the Company. For a company with long-term goals, it has to ensure that the debt capitals are redeemable after a long gestation period.

Government Policies: Sometimes the change in Government policies results in a change in the capital structure of the Company as that change can negatively affect our debt capital and favor equity capital or vice versa.

How to Re-Capitalize a Business?

Recapitalization comes to the rescue when a company is facing a business slowdown as compared to the peers.

The company is very much concerned about the cost of capital. In the case of recapitalization, the focus of the company is to drill down the cost of capital below the return on capital employed. The easiest way of doing so is to issue more and more debt capital.

Obviously, the debt holders will charge a higher than normal rate of interest due to the risk involved in such an organization. Also, such recapitalization can be done only by such lenders who have faith over the business model and their infusion of capital will help the business to survive in near future.

The business is actually managed by the debt holders for time being. Over the period of time, the normal working capital starts through the company.

At a later point in time, the debt holders will issue equity shares at a higher premium to redeem the debt capital and replace the same with equity shares.

Wrapping Up

The capital structure of a company is very crucial for the consistent working of the Organization.
The decision between debt and equity financing depends on the type of business you have and the environment of your organization.

Do some research on the norms in your industry and what your competitors are doing. Investigate several financial products to see what suits your needs or you can contact the business support services that will help you with all your accounting & financial administration to improve your business’s financial growth.

You must ensure to have a proper balance between both for smooth functionary. A wrong decision can have ruined your business.