Capital Structure Meaning, Steps, Factors affecting Capital Structure [Financial Management Notes for NEP and CBCS Pattern]

[Capital Structure Meaning, Steps to Determine Capital Structure, Factors determining Capital Structure, Financial Management Notes, B.Com CBCS Pattern]

Meaning of Capital Structure

Capital structure refers to the mix of sources from where long term funds required by a business may be raised i.e. what should be the proportion of equity share capital, preference share capital, internal sources, debentures and other sources of funds in total amount of capital which an undertaking may raise for establishing its business.

In the words of Robert H. Wessel “The term capital structure is frequently used to indicate the long-term sources of funds employed in a business enterprise”.

In the words of John J. Hampton “Capital structure is the combination of debt and equity securities that comprise a firm’s financing of its assets”.

In simple words, Capital structure of a company is the composition of long-term sources of funds, such as ordinary shares, preference shares, debentures, bonds, long-term funds.

Capital gearing: Capital gearing means taking decision regarding proportion of various types of securities in capital structure. Every company aims at maintaining proper proportion between various types of securities in capital structure so as to reduce its cost of capital. It can be also described as the ratio between the ordinary share capital and fixed interest bearing securities. If ratio of equity is less than the sum of debt capital and preference shares than the situation is said to be high gearing. Again, if ratio of equity is more than the sum of debt capital and preference share than the situation is said to be low gearing. Capital gearing ratio is calculated by dividing sum of equity shares and retained earnings by the sum of debt and preference shares.

How capital structure is determined and factors affecting capital structure of a company

Steps to Determine Capital Structure

1) Compile a list of all components of capital structure viz, equity, preference shares, debt and retained earnings from the recent financial statements.

2) Calculate the sum total of all debt and equity as calculated above.

3) Take each component of capital structure and divide it by the sum total of all components.

4) The calculated figures in step 3 represents what percentage each component of capital structure bears in total capital of the company. These figures can be used to monitor what percentage a company should maintain for debt or equity.

Factors Determining the Capital Structure of a Company

The following factors are considered while deciding the capital structure of the firm.

a)      Leverage: 

It is the basic and important factor, which affect the capital structure. It uses the fixed cost financing such as debt, equity and preference share capital. It is closely related to the overall cost of capital.

b)      Costof Capital: 

Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally long- term finance such as equity and debt consist of fixed cost while mobilization. When the cost of capital increases, value of the firm will also decrease. Hence the firm must take careful steps to reduce the cost of capital.

c)       Nature of the business: 

Use of fixed interest/dividend bearing finance depends upon the nature of the business. If the business consists of long period of operation, it will apply for equity than debt, and it will reduce the cost of capital.

d)      Size of the company: 

It also affects the capital structure of a firm. If the firm belongs to large scale, it can manage the financial requirements with the help of internal sources. But if it is small size, they will go for external finance. It consists of high cost of capital.

e)      Legal requirements: 

Legal requirements are also one of the considerations while dividing the capital structure of a firm. For example, banking companies are restricted to raise funds from some sources.

f)       Requirement of investors: 

In order to collect funds from different type of investors, it will be appropriate for the companies to issue different sources of securities.

g)      Flexibility: 

The capital structure must have flexibility as to increase or decrease the funds as per requirements of the enterprise. Excessive dependence on fixed cost securities make the capital structure rigid due to fixed payment of interest or dividend.

h)      Regularity of Income: 

Capital structure is affected by the regularity of income. If a company expects regular income in future, debenture and bonds should be issued. Preference shares may be issued if a company does not expect regular income.

i)        Certainty of Income: 

If a company is not certain about any regular income in future, it should never issue any type of securities other than equity shares.

j)        Government policy:

Promoter contribution is fixed by the company Act. It restricts to mobilize large, long term funds from external sources. Hence the company must consider government policy regarding the capital structure.