Capital Structure: Definition, Types, Importance & Examples

1. Debt

Debt is usually an amount of money that one party owes to another party. Many companies and people use debt to finance major expenditures that they cannot otherwise afford. It is a form of capital structure that is ideally paid with interest unless the lender accepts the loan. Companies usually issue debts to raise capital in the form of bonds. Both investment firms and individuals can purchase bonds with a coupon rate or a fixed interest. 

Bonds often become due at a future date known as the maturity date, at which point the investor receives the bond’s full face value. In addition, the investor will have received monthly interest payments throughout the years.

Commercial paper, on the other hand, is a type of short-term business loan that matures in 270 days or less.

When it comes to debt, let’s say, for example, Company A chose to launch a separate enterprise called X under a different name, preferring not to use the parent company’s resources. As a result, corporate bonds in the name of firm X were issued. Investors invested in the bonds for two to three years since they understood parent company A was a reliable market entity. Company X, on the other hand, used the cash to expand its operations while paying the interest on time. Finally, it repaid the bonds after two and three years, respectively. 

2. Equity Share Capital

It is a type of capital structure that allows companies to raise finance from the general public. Equity share capital is a form of stock ownership in which investors acquire shares of a company and become shareholders. Furthermore, this capital structure enables investors to be a part of the company’s success and growth. It is also an important component in the corporate market, which companies utilise to fund expansion and operations. Through IPOs or secondary sales, companies thus issue equity shares like private placements and rights issues. 

Equity share capital is known as ordinary share capital and represents shareholders’ ownership rights in a company. Features of equity share capital further include voting rights, dividend rights, residual claim on assets, permanent capital, share transferability and zero obligation to pay fixed dividends. 

To understand equity share capital, let’s say a business issues 100 shares at a price of Rs. 10; the equity share capital is Rs. 1,000. This signifies that the firm has raised Rs. 1,000 from you since you bought equity in it. The earnings of the firm entitle the shareholders or investors who own these shares to a part of the profits and voting rights in certain company-related topics.

3. Vendor Finance

Vendor finance is a short-term capital structure that allows companies or organisations to lend money to borrowers so that they can purchase products, inventories, properties or services from a vendor. This type of financing is also referred to as trade credit – type of delayed loan. This loan product is used when companies don’t have enough funds to purchase a full line of business items and equipment. 

Traditional financial bodies that are hesitant to offer business loans prefer to provide vendor finance to their customers. Traditional financial institutions that are unwilling to lend money for business loans generally are in favour of providing vendor finance to their customers. This financing option can be used at both the manufacturing and post-manufacturing stages of production. Some significant features of vendor finance are hassle-free and minimal documentation, flexible repayment options, the amount of loan depending on business requirements and quick sanctioning. 

When it comes to vendor finance, consider a manufacturing business A wishes to get raw materials worth $10 million from company B. However, due to a liquidity crisis, business A can only pay company B $4 million. In this situation, firm B offers to provide raw materials worth ten million dollars in exchange for four million dollars. Corporation B charges the corporation a nominal interest rate of 10% on the remaining 6 million outstanding amount for a set length of time. Company A may now purchase raw materials worth $10 million by paying $4 million upfront and the balance of $6 million in instalments at 10% interest.

4. Preference Share Capital

It is also known as preference stock. Preference share capital refers to funds allocated by a particular company through the issue of preference shares. If a company offers dividends to the shareholders, preference shareholders will get the payments first. This type of capital structure is issued to raise money for a company. If a company is suffering from losses and is likely to close down, preference shareholders will get paid first, followed by equity shareholders. There are various types of preference share capital. Some of them are cumulative preference shares, convertible preference shares, adjustable preference shares, non-convertible preference shares and participating preference shares. 

As a preference share capital example or a preferred stock example, assume company ‘C’ has 10,000 preference shares to distribute to its investors. These shares are priced at 100 and pay an annual interest rate of 8%. C business did not pay dividends to its preferred shareholders in 2018 or 2019. Prior to the corporation paying its regular shareholders in 2020, preference owners are able to earn $2,400,000 by the end of 2020. This is the total cumulative dividend earned by all stockholders after three years. When the corporation begins paying dividends, preference shareholders will be given priority over other shareholders.