What Is Capital Structure

A firm’s capital structure refers to its unique combination of debt and equity to finance its assets and activities. Businesses regard equity as a more expensive, long-term, and flexible source of finance. Financial flexibility allows them to raise cash on favorable terms when they need money. 

On the other hand, debt is a less expensive, finite-to-maturity capital source. It legally binds corporations to provide predefined cash outflows at an uncertain cost in the future.

The balance sheet includes both debt and equity information. Debt is used to purchase assets for the firm, which is recorded on the balance sheet. A firm’s capital structure may comprise regular and preferred shares and long- and short-term debt. The ratio of short-term debt to long-term debt is considered when assessing a company’s capital structure.

Types of Capital Structure

1. Equity Capital

Equity capitalists invest in a firm in return for ordinary or preferred shares. This is a company’s primary capital, which may add debt financing. Because the company will reimburse investors in case of a business liquidation, their money is at risk. Despite this risk, investors are ready to provide equity capital for the following reasons:

A capital structure’s equity comprises retained earnings and the company’s ordinary and preferred stock. We usually call it invested capital and report it in the shareholders’ equity column of the balance sheet. The capital structure consists of both investment and debt.

2. Debt Capital

Debt capital is the money you borrow and must repay later. This refers to any amount of expansion capital a firm obtains through loans. These loans, like overdraft protection, might be short- or long-term.

One of the primary advantages of debt capital is that it is generally easier to get than equity funding. On the other hand, equity funding is more difficult to obtain since investors only want to invest in organizations they believe have strong growth potential. As a result, acquiring equity funding typically necessitates a more established firm.

3. Working Capital

Working capital is the difference between a company’s current assets and liabilities. A company’s operating capital is a financial indicator used to determine its ability to satisfy short-term debts and unpaid taxes and prepare for future needs.

Companies use working capital to finance operations and meet short-term obligations. For example, if a company has enough operating money, it may continue to pay its suppliers and workers. It can also fulfill other responsibilities, such as interest payments and taxes. A company can satisfy its financial commitments during periods of lower sales by making more supplier purchases with enough working capital to prepare for busy months.

Factors Affecting Capital Structure

• Firm Size

Firm size is highly positively connected to capital structure in empirical studies. Various intuitive explanations may be responsible for this stylized fact, but we have yet to explore them. Small businesses select more considerable leverage when refinancing to compensate for less regular rebalancing—however, more extended periods between refinancing result in lower leverage levels on average.

The link between leverage and business size is negative within one refinancing cycle. Finally, many businesses choose to refrain from leverage. A dynamic economy study indicates that the link between leverage and size is positive in cross-section. So fixed financing costs contribute to the explanation of the stylized size-leverage relationship.

• Profitability

Profitability significantly negatively impacts the capital structure, demonstrating that profitability influences corporate capital structure. However, it also suggests that increased profitability in the form of return on investment, return on equity, and net profit margin causes a drop in the amount of debt in the firms’ capital structures.

Only when debt and equity cooperate in lowering the cost of capital and increasing the firm’s profitability does the optimal capital structure exist. Therefore, the firm’s management must design its capital structure to optimize its worth.

Modigliani-Miller Propositions for Capital Structure

The Modigliani-Miller Theorem, sometimes known as the M&M Theorem, is one of the most significant theorems in corporate finance. In 1958, economists Franco Modigliani and Merton Miller proposed the theory. The M&M theory’s fundamental premise is that a company’s financial structure has no significance on its total worth.

The initial version of the M&M theory was riddled with flaws since it was based on the premise of perfectly efficient markets in which businesses do not pay taxes, and there are no bankruptcy costs or asymmetric knowledge. Following that, Miller and Modigliani expanded their theory to include taxes, bankruptcy costs, and asymmetric information.

Based on the theory:

• Taxes do not exist.
• The transaction costs for purchasing and selling stocks and the bankruptcy cost are zero.
• There is information symmetry. This means that individual investors will have access to the same knowledge as a company, and investors will act rationally.
• Borrowing costs are the same for both investors and businesses.
• There are no flotation costs, such as underwriting commissions, payments to merchant bankers, advertising costs, etc.

Importance of Capital Structure

Every organization must make decisions about how to finance its assets. And finance managers usually face the challenge of determining the optimal debt-to-equity ratio. Investors should generally fund the company’s assets with a balanced mix of debt and equity capital. As a result, capital arrangements usually aim to satisfy the interests of equity owners.

As a result, rather than raising the total cash from shareholders, certain long-term funds might count as loans by paying predetermined yearly fees in the form of bonds or debentures. However, these payments are costs for an entity. This financing technique is employed to serve ordinary shareholders’ interests better.

Conclusion

Every business has distinct needs, notably in terms of financial structure. The cash flow and financial support requirements of a worldwide conglomerate are likely to be more intricate and involved than those of a mom-and-pop firm. 

Capitalization requirements for a firm focusing on consumer items, which may entail less risk, would alter similarly as wants and desires change with the seasons. However, both organizations must still select the financial structure that would allow them to prosper and achieve their goals.