What is Capital Structure?

The capital structure represents the relationship among different kinds of long-term capital. Normally, a firm raises long-term capital through the issue of common shares, sometimes accompanied by preference shares.

Definition

According to Gerestenberg “capital structure of a company refers to the composition or makeup of its capitalization and it includes all long term capital resources viz., loans, reserves, shares, and bonds”.

according to James C. Van Horne “The mix of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity”.
It is the permanent financing of a firm represented by long-term debt, preferred stock, and net worth. So it relates to the arrangement of capital and excludes short-term borrowings. It denotes some degree of permanency as it excludes short-term sources of financing.
Capital Structure

Components of Capital Structure

1. Owner’s capital: Items are included in the owner’s capital:

  • Equity shares: Equity shares are the fundamental source for financing the activities of a business.
  • Preference shares: Those shares which carry the following preferential rights are termed preference shares:
  1. A preferential right as to the payment of dividends during the lifetime of a company.
  2. A preferential right as to the return of capital when the company is wound-up.
  • Retained earnings: These are considered to be the best source of internal financing. This type of financing is considered to be most convenient as no efforts are required to raise such finance.

2. Borrowed Capital:

  1. Debentures: A debenture is an acknowledgment of debt or loan raised by a company. The company has to pay interest to debenture holders at an agreed rate under contractual obligation.
  2. Term Loans: Term loans are provided by banks and other financial institutions which carry a fixed rate of interest for a period of three or more years.

Importance

  1. To reduce the overall risk of the company: When the company makes capital structure before actually getting money from a money supplier it can do many adjustments for reducing its overall risk. At the initial level, the company will try to keep or avoid debt content in its capital structure.
  2. To adjustment according to business environment: Proper planning of capital structure of future sources will be helpful to enlarge the area for getting money. In finance, it is called Manoeuvrability. It means to create mobility of sources of funds by including maximum alternatives in the planned capital structure.
  3. Idea generation of a new source of fund: Good planning of a capital structure will make it versatile to finance managers for getting money from new sources.

Factors Affecting

  1. Economy characteristics: The major developments taking place in the economy affect the capital structure of firms.
  2. Industry characteristics: The following characteristics of the industry affect the capital structure decision of a firm: 1. Level of competition and 2. The life cycle of the industry.
  3. Company Characteristics:
  • size of business
  • age of company
  • stability of earning
  • form of organization
  • credit standing
  • asset structure