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FRICT Approach to Capital Structure Analysis
The FRICT approach is a very important way of measuring the results of the financial structure of a firm. It consists of the following factors −
Let us now take a look at each of these factors in detail.
The capital structure of a company should be within its debt capacity and in no way should it exceed the maximum debt limit. The capacity usually originates from the company’s future cash flows.
The company should have enough cash to meet the demands of the creditors and then should have extra cash to limit any future contingency.
The capital structure should be able to adapt to new conditions quickly. There should be minimum costs and delay associated with a new project for a company if it wants to shift the capital structure.
Finally, the company should be able to provide funds to profitable projects whenever needed.
Risk is dependent on the variability of a firm’s project.
Risk can arise from macroeconomic factors.
The use of excessive debt can also be a reason for the extra risk. Excessive use of debt increases the variability of shareholders’ earnings causing increased risk.
It is notable that if a firm sources funds with equity funding, it will face more risk because equity funding is costlier than debt funding.
Sustained earnings is the safest way to fund projects and it is the least risky option to fund projects.
The capital structure of a company should be able to generate enough income for the owners (shareholders) of a firm.
It should be able to provide the company with the best returns within a limited investment.
The returns of a company should be maximum, and the company should be able to create a situation where the interest is minimum but the returns are the maximum.
The capital structure of a company should have proper control and minimum risk of loss.
The management should have control over the capital structure and the risks of dilution of control should be minimum in closely held companies.
Without proper control and overseeing, it is useless to have a capital structure because capital structure is a process of generating profits by using fewer funds for the foreseeable future.
Timing is an important factor for capital structure. The use of funds in the capital market should be conducive for the companies. Knowing the best time to source funds from the market goes a long way in generating cash flows in the future. Firms looking to make most of the funding must be aware of market conditions and the right moment to source funds.
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