Capital Structure

A business without capital is impossible, and similarly, a business without capital structure is impossible to be scaled. In brief, a capital structure is a combination of different debt and equity funds ratios. A capital structure is generally designed to maximise the development from the raised and available funds. However, every business has diverse operations and aims, owing to which different types of capital structures have emerged. There are three capital structures, namely optimal, equity, and debt. Here’s a detailed guide on the capital structure provided down below.   

What is Capital structure? 

Capital structure can be described by the strategic arrangement and sourcing of different securities, i.e., funds, which are carried with the motive of funding the firm’s long-term operations and development. Debt and equity are the two primary securities or say sources arranged in a capital structure. Before moving further, let’s understand what equity and debt funds are.

Equity Funds 

In capital structure, this can be said as a combination of invested funds and the profit retained on those funds. Equity funds are the funds where the rights are not distributed outside the organisation. Briefly, the debt-free funds are termed equity funds and contributed earnings and retained earnings are examples of equity funds. 

Debt Funds

Debt can be defined as the funds raised by borrowing from other sources. The mandatory outflow of cash is assured to lenders in these funds with decided interest. In debt funds, the fraction of the stake equal to fund value is given to the lender.  

Formation and Motive of Capital Structure

Moreover, every firm has different needs and targets, though all of them have other capital structures. The capital structure of any firm is designed by its board of management. Generally, it is formed via analysing all the firm’s financial information and structured as per its future operations. Although, the success or sustainability of the business is highly reliable on its capital structure. Different types of capital structures are formed that are compatible with other forms of companies.  

Types of Capital Structures

Some factors affect the capital structures, which vary from business to business. Be it the size of business, size of capital, market situations, or business industry, all have a magnificent effect on the capital’s structures. Though, every business forms a different capital structure. There are three main types of capital structures: equity capital structure, debt capital structure, and optimal equity structure. All three differ in their debt-to-equity ratios. 

Optimal Capital Structure

The optimal Capital structure is the combination of both primary funds. This capital structure is formed by equity and debt ratio with the motive of decreasing the Weighted Average Cost of Capital (WACC). In turn, the stakeholder’s wealth increases. The percentages of equity and debt differ from business to business. Any investor looks at a firm’s debt-to-equity ratio to have an overview of its strength. Hence, optimal capital structures help in cash inflow from stakeholders and investors. 

Equity Capital Structure

Equity capital structure is another type of capital structure. Capital structure operating solely on equity capital determines that the firm is debt-free. However, the invested amount and the profit retained on the amount can also be said to be the equity capital. Bootstrapping, friends or family, the stock market, and venture capitalists are sources from which equity capital can be raised, and an equity capital structure can be formed.

Debt Capital Structure

As the name implies, debt capital structure is formed with the funds raised by borrowing while ensuring the return after some time with a surplus. The debt holds a significant stake in the debt-to-equity ratio in this structure. Bank loans, issuance of bonds, commercial papers, or borrowing from other businesses are familiar sources that form the debt capital structure.

How Does Capital Structure Help Businesses?

• It can alert about the business-harming acquisitions and expenditures
• Every business needs to maintain a decent debt-to-equity ratio and debt-to-capital ratio to get support from investors
• Capital structure can help in this case and be altered to decrease the debt stake
• It is needed for the maximising and proper management of all the funds
• It also helps to account for the funds and predict the need for the operations before the instances
• It can help to raise the inflow of cash from the stakeholders
• A balanced capital structure can help adjust the ratio of debt and equity funds as per the situation

Conclusion

We have learned the concept of capital structure and its various aspects. We can now say that capital structure is the strategic arrangement of fundraising while keeping the development and operations of a firm in mind. Equity and debt are the two central funds arranged in the capital structure; however, different types have other arrangements. In brief, an optimal structure focuses on a healthy mix of equity and debt capital, whereas equity and debt structures focus on raising corresponding funds for the firm and its operation. Lastly, we have also discussed the importance of capital structure.