Capital Structure Meaning, Types, Importance30/07/2021 0 By indiafreenotes
The term “Structure” means the arrangement of the various parts. So capital structure means the arrangement of capital from different sources so that the long-term funds needed for the business are raised.
The term capital structure refers to the percentage of capital (money) at work in a business by type. Broadly speaking, it comes in two forms: equity capital and debt capital.
Each type of capital has its pros and cons. A balance is needed to sustain business growth. A large part of wise corporate stewardship and management is trying to create a capital structure that offers the ideal balance of risk and reward for shareholders.
Thus, capital structure refers to the proportions or combinations of equity share capital, preference share capital, debentures, long-term loans, retained earnings and other long-term sources of funds in the total amount of capital which a firm should raise to run its business.
The term capital structure should not be confused with financial structure and Asset’s structure. While financial structure consists of short-term debt, long-term debt and share holders’ fund i.e., the entire left-hand side of the company’s Balance Sheet. But capital structure consists of long-term debt and shareholders’ fund.
So, it may be concluded that the capital structure of a firm is a part of its financial structure. Some experts of financial management include short-term debt in the composition of capital structure. In that case, there is no difference between the two terms; Capital structure and financial structure.
So, capital structure is different from financial structure. It is a part of financial structure. Capital structure refers to the proportion of long-term debt and equity in the total capital of a company. On the other hand, financial structure refers to the net worth or owners’ equity and all liabilities (long-term as well as short-term).
Capital structure does not include short-term liabilities but financial structure includes short-term liabilities or current liabilities.
Asset’s structure implies the composition of total assets used by a firm i.e., make-up of the assets side of Balance Sheet of a company. It indicates the application of fund in the different types of assets fixed and current.
Asset’s structure = Fixed Assets + Current Assets
Vertical Capital Structure: As the name suggests, it is contrary to Horizontal Capital Structure. In a vertical capital structure, the base of the structure is formed by a small amount of equity share capital. This base serves as the foundation on which the super structure of preference share capital and debt is built. The incremental addition in the capital structure is almost entirely in the form of debt. As a little proportion of owner’s capital is necessary for any organization, only this part is financed by equity, remaining financing is done by Debt.
Horizontal Capital Structure: In a Horizontal Capital Structure, the firm has zero debt components in the capital structure mix. The structure is quite stable. Expansion of the firm takes in a lateral manner, i.e. through equity or retained earnings only. The absence of debt results in the lack of financial leverage. Probability of disturbance of the structure is very less. In simple words, all the funds required for a particular project are brought out by the owners only.
Inverted Pyramid Shaped Capital Structure: In the case of an inverted pyramid shaped capital structure, the structure is opposite as that of Pyramid Shaped Capital Structure. It is a capital structure which has a small component of equity capital, reasonable level of retained earnings but an ever-increasing component of debt. Many large organizations go for this type of Capital Structures.
Pyramid Shaped Capital Structure: As the name suggests, a pyramid shaped capital structure has a large proportion consisting of equity capital and retained earnings which have been ploughed back into the firm over a considerably large period of time. The cost of share capital and the retained earnings of the firm are usually lower than the cost of debt. This structure is indicative of risk averse conservative firms. They have a high proportion of equity and considerably a very low proportion 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.
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.
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.
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.
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.