You may hear professional investors, corporate officers, and investment analysts talk about a company's capital structure. The concept is extremely significant because it can affect the return a company earns for its shareholders and whether or not a firm gets through in a recession or depression.
Firstly, let us take a moment to know what capital structure is and why it matters.
What is Capital Structure & Why It Matters
Capital structure is the percentage of capital or money at work in a business by type. A company's capital structure denotes how it funds its operations and growth with various sources of funds, such as bond issues, common stock, preferred stock, long-term notes payable, or retained earnings.
Capital structure is also mentioned as "financial leverage" because each business has to contemplate the optimal ratio for operating its business between debt and equity. Corporate executives have to maintain capital structure in mind to try to either increase shareholders' wealth or increase the company's value.
Each type of capital structure has its advantages and drawbacks, and a considerable part of wise corporate administration and management is trying to find the perfect capital structure concerning a risk or reward payoff for shareholders. This is true for small business owners trying to assess how much of their start-up money should transpire from a bank loan without endangering the business.
Different Forms of Capital Structure
Let us take a moment to get into these different forms of capital structure in detail
1. Equity Capital
Equity capital is the cash put up and possessed by the shareholders. Basically, equity capital consists of two types:
- Contributed Capital: The money that was initially invested in the business in exchange for ownership of shares of stock.
- Retained Earnings: These are the profits from previous years which have been maintained by the company and used to reinforce the balance sheet or fund growth, expansion, or acquisitions.
Many consider equity capital to be the costliest type of capital a company can use because its "cost" is the profit the firm must earn to entice investment. It is the most expensive means to use because of the cost or the size of profit the company must receive to attract investors.
2. Debt Capital
The debt capital refers to borrowed money that is at operation in the business. The cost relies on the health of the company's balance sheet. Debt is the cheaper of the two types of financing capital, as the interest payments on the debt ought to be a tax-deductible expense.
Long-term bonds are mainly the safest kind of debt capital because the company has a lot of time to transpire with the principal while paying only interest until the bond's maturity. Other sources of debt capital can consist of short-term commercial paper.
Following are the different varieties of debt capital:
- Long-term bonds: These are mainly considered the safest type because the company has years to transpire with the principal while paying interest.
- Short-term commercial paper: These amount to billions of dollars in daily loans from the capital markets to fulfill day-to-day working capital needs such as payroll and utility bills.
- Vendor financing: In this case, a company can sell goods before paying the bill to the vendor. This can seriously increase the return on equity but does not cost the company anything.
- Policyholder "float": This is generally considered as the money, in the case of the insurance companies, that doesn't belong to the firm. It gets to use and receive an investment until it has to pay for auto accidents or medical bills.
Importance of Capital Structure
Financing the firm’s assets is a significant problem in every business. There should be a proper blend of debt and equity capital in funding the firm’s assets.
Financial leverage or trading on equity is the use of long-term fixed interest carrying debt, and preference share capital in a company with the equity shares is called. The long-term fixed interest carrying debt is employed by a company to earn more from the utilization of these sources than their cost in order to increase the return on owner’s equity.
The capital structure cannot influence the total earnings of a firm, but it can have an influence on the share of earnings available for equity shareholders.
If you want to know more about capital structure and its forms, Contact us – we’d be delighted to help you learn more.