Saturday, November 24, 2018

Capital Structure in Financial Management

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What is a capital structure?

Capital means funds employed in business for a period of twelve months and above. Capital excludes short-term funds employed in funds, i.e., working capital. Working capital is employed for a short time and hence ignored. Capital structure gives us the various components of capital both debt capital and share capital.

In short, capital structure tells us about how much funds have been brought into business and in what form? It gives us the relationship between debt and equity, known as debt to equity relationship.

What is the need for a capital structure?

Why do we need a capital structure? Cant we do without it? In other words, cant we only have equity or debt instead of both the components? We can, especially equity.

One can have a business enterprise only with equity funds without taking any loans. However, the financial risk that he will be taking would be tremendous, without anybody to share it with.

Referring to debt,we cannot have a business enterprise only with debt. It is impossible as no lender would be willing to give entire amount by way of loan.

Any lender wants the owner to put in some money by way of equity share capital so that the balance funds can be given in the form of loans. The market norm for lending is debt to equity not to exceed 2:1. There would be very few exceptions when this would be higher than 2:1.

To sum up, any business enterprise would have what is known as capital structure. It is advisable for a business enterprise to have both debt and equity components in its capital structure although it is possible to run the business entirely on equity. Further as we have seen in the on leverages, it is beneficial to have a mix of debt and equity as it increases the Earnings Per Share (EPS) to the shareholders.

At the same time, having regard to increasing risk due to increasing debt, it is better to be within the lending norms of 2:1. (Example Rs. 100 lacs by ways of equity and Rs. 200 lacs by way of debt).

Components of a capital structure exclusion of current liabilities and reasons thereof

Share capital:
  • Equity share capital
  • Retained earnings
  • Preference share capital
Debt capital:
  • Debentures
  • Loans
  • Fixed deposits from the public
  • Medium term acceptances for capital goods
  • Bonds
  • Unsecured loans from promoters, friends and relatives
  • Deferred Payment Guarantees
  • Hire Purchase Financing
(The above list is not exhaustive. It is only illustrative.)

Exclusion of current liabilities and reasons thereof
  • They are employed in business for a short period and cannot be considered as part of capital,
  • Some of them do not have any cost attached to them advances received, provision for outstanding expenses, provision for tax, creditors outstanding etc. Whereas all the items of debt capital have interest cost attached to them.
  • In a healthy business enterprise, they are fully covered by current assets and met out of current assets example creditor gets paid out of realisation of sale bill outstanding as a debtor.
Hence strictly speaking, current liabilities are not considered as capital

Factors affecting capital structure or determinants of capital structure

  • The profitability of the organisation the higher the profits more the chances for debt capital because of ability to service higher debt both by way of interest and repayment of principal amount. This is reflected in a very critical ratio called Interest coverage ratio i.e EBIT/I. The higher the ratio, the more the chances of debt in the capital structure.

  • Reliable cash flows the more they are reliable the more the lenders are willing to give debt capital to the enterprise. Once debt is taken cash outflows get fixed for the future. Accordingly the reliability of firms cash flows assumes great significance here.

  • Degree of risk associated with the enterprise the higher the risk less the chances of debt capital and more the chances of equity. Example IT idustry (at least in the late 90s in India) run predominantly on equity.

  • Managements risk aversion attitude conservative managements take less of external debt and try to utilise internal accruals to maximum extent and equity to the extent necessary; on the contrary aggressive managements go in for debt to a larger extent. Examples Sundaram group of companies in Chennai in general and Sundaram Claytons in particular conservative attitude towards debt and debt to equity ratio being less than 1:1. On the contrary, Essar oils have very high debt to equity ratio close to 3:1.

  • Whether the business enterprise enjoys tax concessions in a big way like till recently the IT industry? Owing to high level of exports the IT sector was enjoying 100% tax concession on the exports profits. There was no difference in cost of debt (interest) and cost of equity (primarily dividend) in the absence of taxes. Such enterprises are indifferent to debt and have more of equity only.

  • Availability of different kinds of debt instruments like deep discounted bonds, floating rate notes (where the rate of interest is adjusted to the market rates) etc. that are attractive to the enterprises to go in for maximum debt within the debt to equity ratio norms specified by the lenders or the market. These instruments have entered the market only in the 90s and hence the debt market is getting more and more attractive and limited companies have started using them instead of only depending upon institutional finance.

  • Attitude of the promoters towards financial and management control - if this is high, first preference would be given for debt and then preference shares. Last preference would be given for public equity where financial control gets diluted because of larger number of shareholders and managerial control is likely to be affected.

  • Nature of the industry more competitive = higher equity and less debt; More monopolistic = less equity and more debt. Further depending upon the nature of industry the lenders do have different lending norms. This means that the leverage ratios in a particular industry are more or less uniform. These serve as the benchmark for determining the capital structure for any unit in the industry
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