Capital Structure in Financial Management: Complete Guide

 What is Capital Structure?

Capital structure describes how a corporation finances its assets. This structure is usually a combination of several sources of senior debt, mezzanine debt and equity. Wise companies use the right combination of senior debt, mezzanine debt and equity to keep their true cost of capital as low as possible. Depending on how complex the structure, there may in fact be dozens of financing sources included, drawing on funds from a variety of entities in order to generate the complete financing package. Capital structure is what describes the relationship of these financing sources as they appear on the corporation’s balance sheet. Examples of capital sources that may be included in a corporation’s capital structure are:

• Working Capital
• Equity
• Senior Debt
• Mezzanine Debt
• Alternatives

Definition of 'Capital Structure'

Combination of capital is called capital structure. The firm may use only equity, or only debt, or a combination of equity + debt, or a combination of equity + debt + preference shares or may use other similar combinations. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

How to Determine Your Capital Structure

Determining your corporation’s capital structure is done by calculating the percentage of the total funding that each component represents. By analyzing a corporation’s financial statements, we are able to compile a list of all the capital components on the books. Taking into account all capital components that contribute to the overall capital structure, we are able to calculate the percentage of the total capitalization represented by each capital component. And digging deeper, we will uncover the corporation’s leverage which is described by the ratio of debt financing to equity financing.

Understanding a corporation’s capital structure is necessary to determine which of the many available options is the most fiscally responsible to pursue. Financing with equity versus debt has different capital costs and, as such, will have significantly different long-term effects on the health of a corporation’s finances.

The steps to determining your Capital Structure are as follows:

1. Identify all of the corporation’s capital components by examining the most recent financial statements. Compile a list of all debt and equity, including retained earnings, common shares, debt financing and contributions.
2. Calculate the sum total of all debt and equity you have identified. This figure should equal the sum total of all the corporation’s assets.
3. Take each component of the corporate structure and divide it by the sum total of all components, as calculated in step 2. These calculated figures represent what each source of capital’s percentage is relative to the sum total of the corporate structure.
4. These percentages, if calculated on a regular base, can be used to monitor what mix of debt versus equity a corporation currently holds on its books.

Debt financing is the costliest source of capital versus equity. By monitoring a corporate structure over time and incorporating mezzanine debt into the structure, an effective and fiscally responsible capital structure can be planned and achieved.

How do you design capital structure?

1. Minimize Cost of Capital - The capital structure should use the cheapest sources of finance in proper proportion so that the overall cost of capital remains low and profits increase.
2. Reduce Financial Risk - Excessive debt increases financial risk and interest burden. Therefore, the company should maintain a balanced debt-equity ratio to ensure financial stability.
3. Provide Flexibility - The structure should allow the company to raise additional funds easily whenever needed for expansion, modernization, or emergencies.
4. Ensure Control to Owners - The capital structure should protect the controlling rights of existing shareholders and avoid unnecessary dilution of ownership.
5. Ensure Adequate Finance - It should provide sufficient long-term funds for smooth business operations, growth, and future development.

Capital structure means the mix of equity shares, preference shares, debentures, and long-term loans used by a company to finance its business. A good capital structure should achieve the following objectives: An ideal capital structure balances cost, risk, flexibility, control, and adequacy of funds. Proper planning of capital structure helps a business maximize its value and maintain financial stability.

Factors affecting capital structure decisions

1. Sales Stability: For example, there are two firms; one having stable sales and other having unstable sales, the firm whose sale is relatively stable can safely take on more debt and incur fixed charge in comparison to the firm with unstable sales.
2. Operating Structure: A firm having less operating leverage can imply financial leverage in better way as it will have less business risk.
3. Assets Structure: This factor may affect the capital structure decisions; there are two types of assets which are: general purpose assets and special purpose assets. The real state companies usually use general purpose assets as it makes good collateral.
4. Profitability: The factor of profitability also plays an important role in capital structure decisions. The firms which get high rates of return on investment do not use high debt but they use relatively little debt.
5. Growth Rate: This factor plays an important role in capital structure decision making. It has been observed that faster growing firms mostly rely on external capital as the flotation costs exceeds.
6. Control: there is great effect of control situation on capital structure decisions, because in such a situation management has 50% voting control between the debt and equity. If the management is not in a position to buy or purchase more stock, the other option for it is to use debt for new financing.
7. Taxes: As far as interest is concerned it is no doubt a deductible expense which is much valuable to firms with high tax rates. This is the reason that many firms use much debt because if firm’s tax rate is higher the advantage is also greater.
8. Management Attitudes: Different management attitudes may bring different changes in capital structure decisions. Management may be conservatives or aggressive depending upon the attitude towards risk taking. Both managerial styles exercise according to their own judgments and analytical approaches about the proper capital structure. If the management attitude is conservative it uses less debt, where if the management is having aggressive approach, then it uses more debt to get higher profits.