Capital structure refers to the composition of a firm’s capital that is used to fund its operations and growth; it comprises of debt and equity, which may be in different proportions. Businesses need capital to manage their operations and to support growth, and they usually accesses funds through equity finance, debt finance or retained earnings.
Companies need money to run their business as well as to grow their business. There are also a number of projects that a firm wishes to undertake, that will provide them with some sort of advantage. Once such projects are appraised, the firm needs funds to execute the projects.
Firms primarily have access to these three kinds of funds – retained earnings, debt finance and equity finance.
- Retained earnings (profit generated from business operations)
- Debt Finance
- Equity Finance
Debt and equity finance are external sources, whereas internal sources are retained earnings or funds that can be generated internally by implementing tighter credit controls, delayed payments etc.
There is a cost associated with Capital.
Irrespective of the kind of finance the firm seeks, a company has to incur cost of capital, which it should consider when seeking funds for projects.
Firms always strive to have an optimum capital structure which keeps the cost of capital to an optimum level.
In general, firms avoid dependency on any one type of financing, be it debt or equity. The optimum capital structure is one where a firm uses both equity as well as debt financing so that the cost of capital is reduced; this is also known as the capital structure of the firm.
While firms may use the profits they generate for funding projects, there are times when it is practical for the firm to make use of external financing.
Firms may also seek different options depending on their financial position, whether they need the funds for short term or long term. It is a good practice to use long-term funds to finance long-term projects. This practice protects a firm from external turbulences which may cause credit supply to reduce drastically and from interest rate changes.
Financial ratios, such as Debt to Equity Ratio and Interest Coverage Ratio, tell us more about the capital structure and if the company makes enough money to service its debt.
Debt Finance
Debt financing is the method in which a firm acquires money from individuals or investors and promises them to pay regular interest on that money and pay the principal amount at some time in future.
The advantage of using this source is that it is easily accessible, it is common for smaller and upcoming firms to rely on this source of fund to buy resources that will help them grow. Also, in most cases, a firm is able to claim deductions on the interest paid. There is also no obligation on the firm to pay any dividend or share the profits with it shareholders since the money is borrowed. In some cases, interest on debt turns out to be cheaper compared to other sources of funds.
The downside of debt financing is that interest payment can become significant if the debt is too high. A big loan can pose financial risk to the firm as it can be difficult to pay the interest during difficult economic periods. A firm can even face bankruptcy in worst-case scenario if it is unable to service its debt
.Equity Finance
Equity financing is the process of raising funds by the sale of shares of the firm. A firm may issue shares to meet their short term needs or to fund long-term projects. Equity financing can also come through various means such as IPO, from investors or the promoters. While equity financing is commonly seen as a means to finance publicly listed companies, it can also be used to finance private companies.
The main advantage of using this source of fund is that there is no compulsion on the firm to pay dividend to its shareholders, and they do not have to pay any kind of interest on the amount received through the sale of shares (Jackson et al., 2013). Raising funds through the issuance of shares is also not very difficult for a firm.
There are few cons as well of this method.
The biggest disadvantage being that a firm has to give away part of its ownership. A firm also has to spend some time meeting regulatory requirements. Equity financing also tend to have higher WACC (Weighted average cost of capital) as investors generally expect higher returns from shares due to the higher risk they take.
Retained Earnings
Retained earnings refers to the profit that is generated from a firm’s business operations; it is the profit left with the company after subtracting all the obligations and expenses.
Firms generally use retained earnings to pay dividends or even to fund big initiatives.
Pecking Order Theory
Firms can generate funds by using retained earnings or through debt finance and equity finance.
The pecking order theory of finance suggests in what order a firm should access the funds. The pecking order suggests that firms should always try to access retained earnings first, followed by debt finance, and lastly through equity financing.
This is because there is no cost incurred by the firm on retained earnings, and raising debt capital incurs lower cost compared to equity because investors expect higher returns from equity for the risk they take.
In this case, in order to fund its largescale project, Barclays will require funding from external sources, such as debt and equity. The best capital structure for a firm is the one where the cost of capital is reduced and market value is increased; this is best provided by a mix of debt and equity financing.
References
- Atrill, P., 2020. Financial management for decision makers. Pearson Education.
- Atrill, P. and McLaney, E., 2009. Management accounting for decision makers. Pearson Education.
- Covas, F. and Denhaan, W., 2011. The Cyclical Behavior of Debt and Equity Finance, 101(2), pp.877-99
- Graham, J.R., Leary, M.T. and Roberts, M.R., 2015. A century of capital structure: The leveraging of corporate America. Journal of financial economics, 118(3), pp.658-683.
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