A Guide to Understanding Capital Structure in Business

Hey folks! Every business whether it’s small scale or large scale, it, therefore, needs capital to begin. The requirement for capital can vary as per the scale of business but no business can get initiated without the procurement of some capital. So, it becomes very important to impart a perfect combination of capital structure by understanding the niche of the concept. In today’s blog, we’ll discuss what is capital structure, the factors that influence it, and how it holds a vital place in business.

What is Capital Structure?

In an organization, acquiring and allocating the funds is an integral part and thus, planning and analyzing the need for funds and arranging the same for the overall business operations and growth is referred to as capital structure.

Framing the capital structure lays down the complete mixture of borrowed funds (debt) and the owner’s own funds (equity). Most of the companies evaluate the firm’s Debt-to-Equity (D/E) ratio that tells how risky the capital structure ratio is and how much should the company go for borrowed funds and how the overall fund structure should be constituted.

Components of Capital Structure

Basically, a company’s capital structure consists of two components:

• Debt: It tells about the long term borrowings like debentures, bonds, and the funds that are borrowed from outside sources.
• Equity: These funds are the owner’s own funds that are sourced from within the organization and not from outside sources like equity shares, preference shares, and related funds.

Objectives of framing a capital structure

• To arrange funds from the best available sources
• To create a balance between borrowed funds and equity funds
• To regulate the interest rate of the borrowed funds
• To acquire the funds in such a way that retains the ownership
• To ideally plan the future business prospects
• To analyze and minimize the risk factor

Determinants of Capital Structure

Well, how will be a company’s capital structure is designed depends upon various determinants that affect the overall framework of the fund acquisition. Some of the major determinants are as follows:

✓Business profitability

The extent of capital involved depends on the future prospects of the business and therefore, business profitability is a key determinant of planning the capital structure.

✓Liquidity of the concern

Also, liquidity of the concern is another key factor as it depends on the desired liquidity level as well about how much liquidity is required in the business.

✓Share of control

If the owners of the company wish to retain the ownership and don’t want to share it, they can go for debt capital and vice versa.

✓Market competition

Also, the extent of market competition plays a major role in farming capital structure and is, therefore, another key determinant.

✓Industry nature

The kind of industry also determines the need for capital and the type of capital, business needs. Thus, it’s another important factor that is considered so far.

✓Company traits

Last but not the least, a company’s traits also define the need and the quantum of capital the business requires at present and in the future as well.

Role in capital structure in business enterprise

No doubt, there’s no business that can run a single day without funds and that’s why it calls for a well-planned capital structure to finance the business’ short term as well long term prospects. Below are given some key points telling about the importance of capital structure.

Create leverage in the overall fund structure of the business

The most important role of capital structure is that it helps in leveraging the overall fund requirement and eases the acquisition process for the business owners.

Helps in minimizing the risk of high-interest rate and fund shortage or any other uncertainty

Framing a good mix of capital structure helps in reducing and eliminating the risk of any kind of fund shortage and also helps in minimizing the overall interest rate.

Induce an ideal mix of debt and equity framing an optimal capital structure

For different businesses, there are different needs and thus, an ideal mix of debt and equity is needed so far to create an optimal capital structure.

Envisage the business strategies as per the fund acquisition planning

The business’ strategies and future goals most often rely completely on the funds that are acquired and thus a good mix of capital structure can help in it right away.

Acts as a ladder to funding future business prospects

No business can go on without capital. Thus, a good combination of debt and equity is considered as an ideal capital structure, thereby acting as a ladder for business and its upcoming prospects as well.

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