What is capital structure and its factors in financial management?

  • The main difference between capital structure and financial structure is that financial structure consists of left hand side of a company’s balance sheet, whereas capital structure consists of long term debt and shareholder’s fund.

  • Capital structure is a part of financial structure. Capital structure does not include short term liabilities, but financial structure does.

Importance of capital structure includes −

  • Increase in value of a firm.
  • Utilisation of available funds.
  • Maximisation of return.
  • Minimisation of cost of capital.
  • Solvency/liquidity position.
  • Flexibility.
  • Controlling.
  • Financial risk minimises.

Factors determining capital structure are given below −

  • Trading on equity.
  • Degree of control.
  • Flexibility of financial plan.
  • Choice of investors.
  • Capital market condition.
  • Period of financing.
  • Cost of financing.
  • Stability of sales.
  • Size of a company.

Some of the factors influencing the capital structure are as follows −

  • Cash insolvency − Failure to pay fixed interest liabilities causes risk of cash insolvency. Failure of payment leads to liquidation of a company.

  • Variations of earnings − Higher the debt in capital structure, higher the risk in variation of earnings. If the interest rate is more than return on investment profits decreases, shareholders will get less returns or sometimes no return.

  • Cost of capital − Finance manager should carefully design cost for each source, because that design will define firm finances and its future growth.

  • Government policies − Monetary and fiscal policies will also effect capital structure. Lending policies of financial institutions, SEBI rules and regulations can change financial pattern of a firm.

  • Size of the company − Smaller companies will find to raise debt capital; they have to depend more on equity shares. On the other hand, bigger companies have various securities to raise funds.

  • Nature of business − To have a stable earnings, companies prefer debentures or preference shares and those companies which don’t have or have less earnings will prefer internal resources.

  • Period of finance − Long term funds are raised by issuing debentures or preference shares. For permanent funds raised by issuing equity shares.

  • Taxation − Dividend payable on equity and preference share capital are not deductible for tax purposes. Interest paid on debt is taxable which effects firms’ tax liability.