A business can grow by investing in new plants and equipment for expansion or to enhance its capacity. To fund its expansion, the company has two choices; borrow additional funds from banks or financial institutions or to raise capital by selling additional ownership interests. Both methods have advantages and disadvantages. Management should combine both type of financing to optimize sources. It’s up to the company to decide how they are going to finance their business. Capital structure of a company refers to the mixture of debt and internally generated equity capital to finance its business.
The decision to keep the right mix of debt and equity is referred to as capital structure decision. Management always try to keep the right mix of debt and equity without endangering the business.
What is Equity
Shareholder’s contributed capital and retained earnings of the company is referred to as equity finance. Its shown on the balance sheet as a source of money.
Contributed capital means the amount shareholders are originally contributed to the company in exchange of shares. Retained earnings is the amount of profit that the company has kept every year from its net profit for future expansion.
Its also known as Net worth of the company. In other words, as the basic source of financing, own capital/net-worth represents owners investment into the company and the accumulated wealth generated over the years. Therefore, own capital can also be referred as paid up capital plus retained earnings. Owner’s capital caries incidence of ownership and the right to profits.
What is Debt
Debt is the amount that is borrowed from outsiders instead of raising from shareholders. This means debt or third party capital creates an obligation to be paid. If the company finances its activities with debt, the creditors expect the company to repay interest and principal as promised, failure to which may result in legal actions by the lenders.
Cost of capital structure depends on the cost of debt. In economic downturn, if cost of debt goes up and earnings comes down, company might be in financial distress. Financial distress is a situation where company’s management are forced to to makes decisions to satisfy its legal obligations.
If the company is funded by equity only, company has no legal obligations to pay anything from its earnings.
Why capital structure matters
A company may finance its operation by increasing debt or net worth. Debt and equity mix of company’s capital structure matters for following reasons;
- It influence company’s net profits earned for shareholders,
- It decides whether or not a firm can survive recession or depression.
To know the extend up-to which debt is used in capital structure, you can find debt to equity ratio and interest coverage ratio. To know the extent up to which company’s assets are financed with debt, you can calculate debt to assets ratio.