Capital Structure: Definition, Types, Importance & Examples
Table of Contents
- jaro education
- 27, September 2023
- 4:00 pm
Capital structure is the combination of equity and debt that is employed to finance the operations and assets of the company. In business, equity is a long-term and expensive source of financing offering greater flexibility. On the other hand, debt is a cheaper capital market source that legally binds a company to make specific cash flows on a predetermined timetable with the need to refinance at an unknown cost in the future. When the capital structure is optimal, there will be a trade-off between the cost-effectiveness of debt in comparison to the greater cost of equity and the costs of a financial crisis.
Types of Capital Structure
It is crucial to be familiar with the different forms of capital structure in order to evaluate a company’s state and its prospects. Below are the types of capital structure:
1. Debt
Debt capital includes the procurement of financial capital budgeting by the business entity. This could be in any form: loans, bonds, and debentures. These refer to funds companies have obtained from other unconnected sources on agreed terms and conditions, whereby the borrowing company is supposed to return the borrowed sum, together with some extra amount in the form of interest, within some stipulated duration. Despite this, debt financing has certain advantages, including tax benefits in that interest rates are recoverable as expenses.
However, it also incurs credit risk since, under this type of facility, the borrower is expected to pay the principal with interest, which puts a strain on cash flow if not properly managed.
2. Equity Share Capital
Equity share capital shows the ownership of the company and is issued when the company floats its share in the market. Those who invest in equity shares become part owners of the company and can even receive a part of the profits of the company, which may be in the form of dividends. Unlike debt, equity does not involve regular payments, which is why it can have a flexible type of financing.
Nevertheless, offering equity can water down the stock stakeholders and will generally affect the control of the original owner.
3. Vendor Finance
Vendor finance is a popular capital structure in which a supplier of goods or services offers a product or service on those terms that may defer or postpone payments for some time. This also helps in managing cash since it reduces the businesses’ cash costs as they occur over time.
Conventionally, the credit period for the vendors extends to 60-90 days, within which the company is free to use the products sold by the vendors without making cash payments upfront. This type of financing literacy is good because the cost of capital is relatively less than that of conventional lines of credit because interest is generally charged post-credit period.
4. Preference Share Capital
Preference share capital implies the issue of shares that give preference shareholders certain privileges over ordinary shareholders in terms of dividends and in the event of the company’s winding up. The preferred shareholders get fixed returns before the payout of dividends to the common shareholders, making this form of capital less volatile for investors than equity shares.
However, preference shares do not generally have voting rights. As a result, shareholders have minimal control of company operations. Such capital structure makes it possible for organisations to fund their activities without surrendering control and, at the same, offer more stable returns than those that come with common equity.
Capital Structure Formula with Examples
The capital of a company is expressed as a percentage, is calculated using the following capital structure formula:
Capital Structure (%) = % of common equity + % of debts + % of preferred stock
To determine these percentages, use the following methods:
- Common Equity Weight (%) = Common Equity ÷ Total Capitalization
- Debt Weight (%) = Total Debt ÷ Total Capitalization
- Preferred Stock Weight (%) = Preferred Stock ÷ Total Capitalization