Capital Structure – Meaning and Factors Determining Capital Structure

Overview of Capital Structure

What is Capital Structure?

As we can see, Capital Structure consists of two words. One is ‘Capital’, and another is ‘Structure’. Capital refers to the money, and Structure refers to the arrangement of that money from different sources. So basically, capital structure is how a company manages to finance its operations. There are two major sources to raise funds for Capital Structure: Debt and Equity.

If the company decides to raise funds through debt, they are liable to pay some interest to the holders on a regular basis, mostly on a yearly basis. No matter if the company is in loss or profit, the company is liable to pay them in all cases. On the other hand, if the company chooses equity to raise funds, then it will be liable to pay the stakeholders only if the company earns a profit.

When the holders buy some voting rights in the company through equity shares, they are risking their money, but they still choose to go ahead. This is because of the fact that they know if there are chances of losing all the money, there are also chances to earn higher profits. That said, a company or an individual must go through deep research about the yearly statistics and reports of the equity you are investing in to reduce the risk of losing the money.

Factors Determining Capital Structure

 1. Not willing to lose Control – When the management of the company is not ready to share its control or have any kind of interference from the security holders. They prefer to raise funds through preference shares and debentures.

 2. Dynamic Market Conditions – When the market is at its boom, the investors take more risk, and this is the greatest chance for companies to raise funds through equity.

 3. Flexibility– The company prefers to adopt the mix of debt and equity also sometimes. This is just to balance the risk as per the changing market environment.

 4. Nature of Business– Companies having sufficient earnings can afford high capital gearing, but the ones, which are subjected to fluctuations depend more on Equity and Preference shares.

 5. Cash Flow – The choice also depends on the liquidity of the company if it has sufficient cash to meet the chances. It can go ahead with debt funds as well.

 6. Personal Considerations– It depends on the management of how they want the capital structure to be. If they want, they can prefer to use more debt.

 7. Assets Structure – Before choosing the structure, the composition of assets is required to be taken into consideration. If fixed assets are more, then the preferred choice of companies to raise funds will be more of long term debts.

 8. Purpose of raising funds – If the purpose is productive, then debt financing, i.e. Issue of debentures is an appropriate way to raise funds as they can pay the interest out of the profit they earn. But, if it is for something general on a long-term basis, then equity capital should be preferred.

 9. Time duration – If the funds are required on a permanent basis, then the best way to raise funds is equity, but if funds are required for a limited period of time, then debentures or Redeemable preference shares can be the right choice.

 10. Legal requirement– The choice between equity and debt can be affected due to certain guidelines of the government. There are certain legal restrictions that are required to be considered before making the decision.

 11. Requirements of investors– This factor can also influence decision making. This also depends on the type of investor, for example, if the investors are bold, they’ll take all types of risk to gain more profit and can opt for equity, but those who are cautious will opt for debentures and preference shares for stable returns.

Hope now you have a clear idea of capital structure as well as its factors.