Capital Structure

The capital structure is the particular combination of debt and equity used by a company
to finance its overall operations and growth. Debt comes in the form of bond issues or loans, while
equity may come in the form of common stock, preferred stock, or retained earnings. Short-term
debt such as working capital requirements is also considered to be part of the capital structure.
Both debt and equity can be found on the balance sheet. Company assets, also listed on the balance
sheet, are purchased with this debt and equity. Capital structure can be a mixture of a
company's long-term debt, short-term debt, common stock, and preferred stock. A company's
proportion of short-term debt versus long-term debt is considered when analyzing its capital
structure. When analysts refer to capital structure, they are most likely referring to a firm's debt-
to-equity (D/E) ratio, which provides insight into how risky a company's borrowing practices are.
Usually, a company that is heavily financed by debt has a more aggressive capital structure and
therefore poses greater risk to investors. This risk, however, may be the primary source of the
firm's growth.

Debt is one of the two main ways a company can raise money in the capital markets. Companies
benefit from debt because of its tax advantages; interest payments made as a result of borrowing
funds may be tax deductible. Debt also allows a company or business to retain ownership, unlike
equity. Additionally, in times of low interest rates, debt is abundant and easy to access.

Equity allows outside investors to take partial ownership in the company. Equity is more expensive
than debt, especially when interest rates are low. However, unlike debt, equity does not need to be
paid back. This is a benefit to the company in the case of declining earnings. On the other hand,
equity represents a claim by the owner on the future earnings of the company.

Measures of Capital Structure

Companies that use more debt than equity to finance their assets and fund operating activities have
a high leverage ratio and an aggressive capital structure. A company that pays for assets with more
equity than debt has a low leverage ratio and a conservative capital structure. That said, a high
leverage ratio and an aggressive capital structure can also lead to higher growth rates, whereas a
conservative capital structure can lead to lower growth rates. It is the goal of company management
to find the ideal mix of debt and equity, also referred to as the optimal capital structure, to finance
operations. Analysts use the debt-to-equity (D/E) ratio to compare capital structure. It is calculated
by dividing total liabilities by total equity. Savvy companies have learned to incorporate both debt
and equity into their corporate strategies. At times, however, companies may rely too heavily on
external funding, and debt in particular. Investors can monitor a firm's capital structure by tracking
the D/E ratio and comparing it against the company's industry peers.
The importance of designing a proper capital structure is explained below:

Value Maximization: Capital structure maximizes the market value of a firm, i.e. in a firm having
a properly designed capital structure the aggregate value of the claims and ownership interests of
the shareholders are maximized.

Cost Minimization: Capital structure minimizes the firm’s cost of capital or cost of financing. By
determining a proper mix of fund sources, a firm can keep the overall cost of capital to the lowest.

Increase in Share Price: Capital structure maximizes the company’s market price of share by
increasing earnings per share of the ordinary shareholders. It also increases dividend receipt of the
shareholders.

Investment Opportunity: Capital structure increases the ability of the company to find new
wealth- creating investment opportunities. With proper capital gearing it also increases the
confidence of suppliers of debt.

Growth of the Country: Capital structure increases the country’s rate of investment and growth
by increasing the firm’s opportunity to engage in future wealth-creating investments.

Patterns of Capital Structure: There are usually two sources of funds used by a firm: Debt and
equity. A new company cannot collect sufficient funds as per their requirements as it has yet to
establish its creditworthiness in the market; consequently they have to depend only on equity
shares, which is the simple type of capital structure. After establishing its creditworthiness in the
market, its capital structure gradually becomes complex.

A complex capital structure pattern may be of following forms:

i. Equity Shares and Debentures (i.e. long term debt including Bonds etc.),
ii. Equity Shares and Preference Shares,
iii. Equity Shares, Preference Shares and Debentures (i.e. long term debt including Bonds etc.).

However, irrespective of the pattern of the capital structure, a firm must try to maximize the
earnings per share for the equity shareholders and also the value of the firm.

LONG TERM FINANCE?

The funds which are not paid back within a period of less than a year are referred to as long term
finance. Certain long term finance options directly form a part of the permanent capital of the firm.
In such cases, the repayment obligation does not even arise. A 20 year mortgage or 10 year treasury
bills are examples of long term finance. The primary purpose of obtaining long-term funds is to
finance capital projects and carrying out operations on an expansionary scale. Such funds are
normally invested into avenues from which greater economic benefits are expected to arise in
future.
SOURCES OF LONG TERM FINANCE
The nature of such finance can be ownership as well as borrowing or a hybrid of the two. Some of
the main sources of long term finance are listed below

EQUITY

Equity is the foremost requirement at the time of floatation of any company. They represent the
ownership funds of the company and are permanent to the capital structure of the firm. The equity
can be private or public. Private equity is raised from institutional or high net worth individuals.
Public equity is raised by issuing shares to the public at large which are subscribed to by retail
investors, mutual funds, banks and a pool of other investors. On the flipside, equity is an expensive
variant of long term finance. The investors expect a high return due to the extent of risk involved.

Pro: No repayment obligation arises during the lifetime of the company.

Con: Issue of shares via an IPO in the primary market is a costly affair and entails several legal
and banking expenses.

BONDS

Bonds are debt instruments involving two parties- the borrower and the lender. The borrower can
be the government, a local body or a corporation. They provide fixed interest payments at periodic
intervals and are redeemable at a predetermined date in future. Bonds are normally issued against
collateral and are therefore a highly secured form of long term finance. Bonds may prove to be a
very cost effective source of funds in a bullish market.

Pro: Easier to raise funds via bonds, especially federal bonds since they enjoy complete investor
confidence.
Con: Subject to interest rate risk. Therefore the price of bonds will fall with an increase in
prevailing interest rates.

TERM LOANS

Term loans are borrowings made from banks and financial institutions. Such term loans may be
for the medium to long term with repayment period ranging from 1 to 30 years. Such long term
finance is generally procured to fund specific projects (expansion, diversification, capital
expenditure etc) and is, therefore, also known as project finance. Term loans can be sourced by
both small as well as established businesses. Also, the interest rates are relatively low and are
negotiated depending upon the duration of the loan, nature of security furnished, the risk involved
etc.
Pro: Term loans can be sanctioned immediately within a matter of days depending upon the
financial health of the firm.
Con: Heavy collaterals are required to be furnished to obtain a term loan. Even then, the amount
of loan disbursed remains a fraction of the asset value.

INTERNAL ACCRUALS

Internal accruals are nothing but the reserve of profits or retention of earnings that the firm has
created over the years. They represent one of the most essential sources of long term finance since
they are not injected into the business from external sources. Rather it is self-generated and
highlights the sustainability and profitability of the entity Also internal accruals are owner’s funds
and therefore create no charge on the assets of the company.

Pro: The firm incurs absolutely no cost in raising such funds.

Con: It may be a source of conflict since the shareholders may prefer payout of dividends rather
than a plough back.

Accruals are revenues earned or expenses incurred which impact a company's net income on
the income statement, although cash related to the transaction has not yet changed hands. Accruals
also affect the balance sheet, as they involve non-cash assets and liabilities. Accrual accounts
include, among many others, accounts payable, accounts receivable, accrued tax liabilities,
and accrued interest earned or payable.
Accruals and deferrals are the basis of the accrual method of accounting, the preferred method
by generally accepted accounting principles (GAAP). Using the accrual method, an accountant
makes adjustments for revenue that has been earned but is not yet recorded in the general
ledger and expenses that have been incurred but are also not yet recorded. The accruals are made
via adjusting journal entries at the end of each accounting period, so the reported financial
statements can be inclusive of these amounts. The use of accrual accounts greatly improves the
quality of information on financial statements. Before the use of accruals, accountants only
recorded cash transactions. Unfortunately, cash transactions don't give information about other
important business activities, such as revenue based on credit extended to customers or a
company's future liabilities. By recording accruals, a company can measure what it owes in the
short-term and also what cash revenue it expects to receive. It also allows a company to record
assets that do not have a cash value, such as goodwill.

In double-entry bookkeeping, the offset to an accrued expense is an accrued liability account,

which appears on the balance sheet. The offset to accrued revenue is an accrued asset account,
which also appears on the balance sheet. Therefore, an adjusting journal entry for an accrual will
impact both the balance sheet and the income statement.

Examples of Accruals

Let's look at an example of a revenue accrual for an electric utility company. The utility company
generated electricity that customers received in December. However, the utility company does not
bill the electric customers until the following month when the meters have been read. To have the
proper revenue figure for the year on the utility's financial statements, the company needs to
complete an adjusting journal entry to report the revenue that was earned in December.
It will additionally be reflected in the receivables account as of December 31, because the utility
company has fulfilled its obligations to its customers in earning the revenue at that point. The
adjusting journal entry for December would include a debit to accounts receivable and a credit to
a revenue account. The following month, when the cash is received, the company would record a
credit to decrease accounts receivable and a debit to increase cash.

An example of an expense accrual involves employee bonuses that were earned in 2019, but will
not be paid until 2020. The 2019 financial statements need to reflect the bonus expense earned by
employees in 2019 as well as the bonus liability the company plans to pay out. Therefore, prior to
issuing the 2019 financial statements, an adjusting journal entry records this accrual with a debit
to an expense account and a credit to a liability account. Once the payment has been made in the
new year, the liability account will be decreased through a debit, and the cash account will be
reduced through a credit.

Another expense accrual occurs for interest. For example, a company with a bond will accrue
interest expense on its monthly financial statements, although interest on bonds is typically paid
semi-annually. The interest expense recorded in an adjusting journal entry will be the amount that
has accrued as of the financial statement date. A corresponding interest liability will be recorded
on the balance sheet.

Advantages and disadvantages of internal accruals

Internal accruals are considered by many corporate management to have the following
advantages and disadvantages:

Advantages of using internal accruals

Internal accruals are readily available. Corporate management does not have to negotiate with
outsiders or lenders.
The use of internal accruals in contrast to external equity eliminates issue costs and losses on
account of under-pricing
There is no dilution of control when a project company relies on internal accruals.
The stock market generally views an equity issue with skepticism. Internal accruals, however ,
do not carry such negative connotation

Disadvantages of using internal accruals:

 The amount that may be available by way of accruals may be limited.
 The opportunity cost of retained earnings is quite high as it is equal to the cost of equity
i.e. retained earnings, in essence represent dividends foregone by equity shareholders.
 The opportunity cost of depreciation - generated funds is equal to the weighted average cost
of capital of the project company.
 Many project companies do not appreciate the opportunity costs of retained earnings
and depreciation –generated funds. They tend to i m p u t e a l o w c o s t t o i n t e r n a l
a c c r u a l s . C o m f o r t e d b y t h e e a s y availability of internal accruals and the
notion that they have a low cost, managements may invest in such sub- marginal
projects that destroy shareholder value.
VENTURE CAPITAL

This form of financing has emerged with the growing popularity of start-up culture worldwide.
VC firms invest into companies at their inception or seed stage. They are constantly on a watch
out for firms demonstrating high growth potential. Their investment takes the form of ownership
funds and forms a part of the permanent capital of the firm. Venture capitalists also have a
predetermined exit strategy before they invest. This results in the target company being listed or a
secondary sale to another VC firm.

Pro: The companies who are yet to establish steady cash flows are not burdened by any covenants
which entail debt financing. There is no repayment obligation until the firm is profitable.
Con: Firm ends up losing a significant piece of the ownership pie to such Vc’s.

SHORT TERM VS LONG TERM FINANCE

A comparative analysis of short and long term financing will further aid in effectively grasping
the benefits of long term finance. Short and long-term sources of finances cater to a different set
of requirements for different borrowers. The table below illustrates some points of distinction.

Short-Term
Finance Long-Term Finance

Typically repayable within Have a longer time span varying from 1

Duration one year or less. to 30 years.

Obtained to fund
temporary shortfall in
the working capital,
repayment of current Obtained to fund the purchase of PPE
Requirements liabilities etc. or capital projects on a wide scale.

Collaterals are the most primary

Do not create a charge on condition for the furnishing of long
Collaterals the assets of the firm. term finance.

Interest rates are stable and the terms of

the loan offer flexibility such as
Interest rates are unstable prepayment options, re-negotiation of
and are vulnerable to interests upon improvement in credit
Terms of loan inflationary forces. rating etc.

A large volume of funds can be

Used to raise funds in obtained. However the same is
Volume of funds limited amount since they restricted to the nature of securities
 are repayable in the near furnished, the credit rating of borrower,
future. etc.

Overdraft, Credit Cards, Leasing, Term Loans, Public Deposits,

Examples Line of Credit. Bonds.

Equity Shares and Preference Shares:

A Company can issue two types of shares viz. Equity Shares and Preference Shares. Equity shares
are also known as Ordinary Shares. While Preference shareholders enjoy the benefit of receiving
their dividend distribution first; the equity shareholders enjoy voting rights in major company
decisions, including mergers or acquisitions. Preference shares have the right to receive dividend
at a fixed rate before any dividend is paid on the equity shares. Further, when the company is
wound up, they have a right to return of the capital before that of equity shares.

The key differences between preference shares and equity shares are listed in the following table:

Difference between Preference Shares and Equity shares

Basis of Distinction Preference Shares Equity Shares

Rate of Dividend Paid at fixed rate May vary , depending upon

the profits

Arrears of Dividend Get accumulated for cumulative No accumulation

preference shares

Preferential Rights Before Equity shares After

Winding up Have a right to return of capital before Only paid when preference
equity shares . This means they are share capital is paid fully
safer.

Voting Rights No voting rights Voting rights

Right to participate Have NO right Have right

in Management

Apart from the above, the preference shares may carry some more rights such as the right to
participate in excess profits, which a specified dividend has been paid on the equity shares or the
right to receive a premium at the time of redemption.
The preference shares are safer investments than the equity shares. In case the company is wound
up and its assets (land, buildings, offices, machinery, furniture, etc) are being sold, the money that
comes from this sale is given to the shareholders. After all, shareholders invest in a business and
own a portion of it. Please note that usually, the preference shares are most commonly issued by
companies to institutions. That means, it is out of the reach of the retail investor. For example,
banks and financial institutions may want to invest in a company but do not want to bother with
the hassles of fluctuating share prices. In that case, they would prefer to invest in a company’s
preference shares. Companies, on the other hand, may need money but are unwilling to take a loan.
So they will issue preference shares. The banks and financial institutions will buy the shares and
the company gets the money it needs. This will appear in the company’s balance sheet as ‘capital’
and not as debt (which is what would have happened if they had taken a loan).

Preference Shares are NOT traded in stock exchange. This also means they are not ‘liquid’ assets;
there’s little scope for the price of these shares to move up or down. On the other hand, ordinary
or equity shares are traded in the markets and their prices go up and down depending on supply
and demand for the stock. But, that does not mean the investor is stuck with his shares. After a
fixed period, a preference shareholder can sell his/ her preference shares back to the company.
This cannot be done with the ordinary shares. Ordinary shares can be only sold to another buyer
in stock market. One can sell the ordinary shares back to the company only if the company
announces a buyback offer.