Every business requires a substantial amount of capital to set up operations in a country. Let’s look at how a company sets up its capital structure and the factors that impact it.
What is Capital Structure?
A crucial aspect of starting a business is its capital. Debt and equity are the two types of capital sources for a company, and a business utilizes them in different ways. It is a combination of equity and debt that a company uses to finance its overall operations of the company.
Capital Structure: Definition
Capital structure is the relationship between the various forms of financing such as debenture, preference share capital, and equity share capital. Investing the firm’s assets is a very crucial problem in every business, and as a general rule of thumb, there should be a proper mix of debt and equity capital in financing the firm’s assets.
The use of long-term fixed interest-bearing debt and preference share capital along with equity shares is called financial leverage or trading on equity. A firm employs the long-term fixed interest-bearing debt to earn more from the use of these sources than their cost to increase the return on owner’s equity.
Capital Structure: Types
The capital structure of a company is the structure of capital by using different sources of funds which consists of equity and debt. The different types of funds raised by a firm include shares, earnings, loans etc.
There are two types of Equity Capital:
Retained earnings are the company profit kept separately by the organisation, which helps in strengthening business operations.
Contributed capital is the money company owners have invested in or received from shareholders.
Debt capital is the borrowed money a company utilises in its business.
There are two forms of debt capital.
Long Term Bonds
Long Term bonds are the safest types of debts because of their extended repayment period, and the company pays only the interest on the loan needed.
Short Term Commercial Paper
Short Term Commercial Paper is a type of short-term debt used by companies to raise capital for a short time.
Optimal Capital Structure Of A Business
An Optimal capital structure for a business is a perfect mix of debt and equity financing that helps to maximise the value of a company in the market. Yet, it minimises its cost of company capital.
Capital structure varies across different industries. A company involved in mining, petroleum or oil extraction, a high debt ratio is not advisable. Whereas, an insurance company or banking entity has a massive debt as part of its business capital.
Importance of Capital Structure
Capital structure determines the overall stability of a firm. A firm with a sound capital structure has a higher chance of increasing the price of its shares and securities, which further lead to a higher company valuation.
It ensures that the available funds are used effectively and prevents over or under capitalisation. It also helps the company in increasing profits with higher stakeholder returns.
A proper capital structure also helps in maximising shareholder’s capital while minimising the overall cost of the money and provides firms with the flexibility of increasing or decreasing the debt capital as per the situation.
Factors Determining Capital Structure
Costs of capital:
Costs of capital incurred when a company is raising money from different funds. A firm should generate sufficient revenue to meet its capital costs and achieve financial growth.
Degree of Control:
The equity shareholders of a company have more rights than its preference shareholders or debenture shareholders. The shareholders determine the capital structure of a firm, and it limits their voting privileges.
Trading on Equity:
If a firm uses more equity as a source of finance, it needs to borrow new funds to increase company returns. Equity trading happens when the rate of return on the company’s total capital is more than its rate of interest on debentures or newly borrowed money.
Government laws also impact a company’s capital structure. Changes in national monetary and fiscal policies result in shifts in capital structure decisions.
Before conducting the business activity in the UAE a company must be clear about the way the capital structure works as it has huge bearings on the future of the company. If you want to consult professionals about the capital structure of your company then you can consult the experts at Jaxa Chartered Accountants.
JAXA has made a name for themselves and is considered as one of the top financial firms in the United Arab Emirates. If you have any doubts about the services JAXA provides, feel free to Contact Us. We will be happy to answer all your queries.