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8 Factors That Influence Capital Structure of a Business

Capital Structure

Capital structure determines a firm’s fiscal and organizational and health. Financial executives create optimal capital structure by diversifying company debts and outstanding shares. Business analysts evaluate capital structure by reviewing several corporate characteristics – such as long-term financial assets, executive control, planning fluidity and historical performance. Optimal capital structure is the key to decreasing expenses and increasing profits for stakeholders.

Structuring Capital for Enhanced Operations

By understanding a company’s capital structure, stakeholders can determine whether a firm follows sound financial practices. It is important not to confuse capital structure with market capitalization. Long-term asset diversification is one indicator of corporate health. [1] Company executives issue equity shares, preference shares and assume long-term loans to raise capital. For optimal diversification, finance executives create a balance between risk and return that maximizes stock value and minimizes the cost of money.

Firms trade on equity, or company ownership, to borrow capital against equity shareholder profits. Equity shareholder profits originate from income generated by issuing securities to preferred stockholders and debenture holders. In theory, shareholders benefit when firms use this financing practice, because the interest rate on funds are lower than standard loan rates.

A firm’s security composition determines organizational ownership and falls under two classifications – highly geared and low geared. Highly geared companies secure financial assets using a small percentage of equity capitalization, while low geared firms secure mostly equity capital.

Capital structure optimization is crucial for short- and long-term growth. Financial analysts review the following 8 factors, among others, to evaluate capital structure.

Factor 1: Controlling Interest
Among publicly held companies, the elected organizational directors represent equity investors. Equity shareholder votes carry more leverage than preference stockholder votes or debenture holder votes. Preference shareholders have significantly less voting privileges, while debenture holders have no voting rights.
Firms desiring to retain company decision-making rights secure funds mostly through debenture holders rather than equity holders. Additionally, firms typically issue a mix of securities to cater to varying risk tolerances. Equity investors assume substantial risk, while loan and debenture holders trade lower returns for safer investments.

Factor 2: Emergency Preparedness
Responsive financial planning factors into preparing a firm for market changes, such as revenue fluctuations and financing availability, to ensure timely loan repayments. Equity capital is not liquid. Therefore, firms issues securities such as debentures to improve corporate financial responsiveness.

Factor 3: Economic Conditions
The economy influences stock prices. When the financial market is low, companies form debenture and loan capital structures. During market highs, firms maintain equity capital structures.

Firms secure short-term loans from banks and other lending institutions and long-term loans by issuing stocks and debentures. The cost of money, as dictated by economic conditions, affects capital structure when a firm raises funds with securities. Debenture instruments are more beneficial for firms relative to equity share disbursements, which garner higher returns and therefore result in higher corporate expenses.

Factor 4: Solid Fiscal Performance
Consistent historical revenue indicates that a firm can cover expenses over time. Firms must pay some securities, such as debentures, regardless of profits. Therefore, healthy sales indicate an enterprise’s ability to meet financial obligations. When revenue is down, organizations seek equity financing for flexible repayment terms.
Smaller firms typically procure bank loans and organizational profits for operations, while larger firms issue shares in combination with commercial loans.

Factor 5: Financial, Business and Operational Risk
Expense consistency affects capital structure. How expenses fluctuate due to unforeseen circumstances is important. Natural disasters, for instance, stunt short-term revenue by hampering sales and long-term revenue with productions blockages.

The economy where a firm conducts business is also subject to unforeseen risks. In the contemporary business world, size no longer assures economic survival. Therefore, finance executives attempt to consider every possibility imaginable to mitigate negative economic events.

Factor 6: Cash Flow and Debt
Cash flow to debt analysis during high and low revenue cycles determines an organization’s borrowing capacity. A firm’s ability to pay expenses and loans determines debt capacity. Some firms operate in volatile financial environments affecting their ability to meet financial obligations. These firms typically operate with minimal debt to ensure continued operations.

Startup companies normally borrow in excess, anticipating financial needs before the firm breaks even in the future. While these firms often finance operations with equity, future fundraising proves difficult. Other startups secure loans using physical company assets.

Factor 7: Interest Rate Changes
Interest rate changes affect company profits. [3] Firms secure loans with different terms, such as fixed or floating interest rates. If a firm operates successfully, but overlooks potential interest rate changes, the firm may fall behind in payments.

The Federal Reserve determines rate changes based on the country’s economic circumstances. They lower rates when they want to stimulate economic activity, such as consumer spending. This also makes it easier, and more cost-effective, for businesses to secure loans. During low interest rate cycles, enterprises borrow finances for research, development and expansion. When the Federal Reserve raises rates, businesses curtail borrowing, because it is difficult to realize a return-on-investment with high interest rate loans.

Factor 8: Debt and Equity Financing
Substantial equity capital, as opposed to debt capital normally indicates optimal overall financial performance. [3] However, firms benefit from both instruments, depending on their circumstances.

With debt financing, company founders retain ownership and management control. For smaller businesses, debt instruments allow greater financial latitude. Once the business owner pays the loan, they are no longer obligated to the lender, and loan instruments do not require complex reporting.

Equity financing requires company owners to surrender partial corporate control. However, startup firms frequently accept this compromise to secure financing. While equity investors knowingly assume high risk for more benefits, including higher returns, they also research startup companies thoroughly to maximize return potential.

Determining Capital Structure

While analysts cannot predict future events, these factors indicate whether a firm can survive changing financial circumstances. [2] Myriad factors affect an organization’s financial performance. However, financial analyses help stakeholders evaluate risk using quantifiable factors.

An effective capital structure analysis requires in-depth research. Established firms make capital structure assessment and ongoing practice. A detailed capital structure analysis helps organizations determine important policies, such as pricing, acceptable loan terms and resource allocation. Capital structure optimization reduces loan default risk, while increasing revenue and shareholder returns.

For an accurate evaluation, financial analysts dig deep into company records to uncover how internal and external factors may affect company finances. Firms that successfully optimize their capital structures respond effectively to negative and positive changes in the business environment.

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Today’s employers seek finance professionals who understand the links between the economy and financial markets; professionals who are adept at forecasting potential impacts and timing investments for maximum return. This is the level of expertise you can acquire with the Ohio University online master of financial economics.

Sources:
[1] http://www.managementstudyguide.com/capital-structure.htm#
[2] http://www.kpmg.com/US/en/IssuesAndInsights/ArticlesPublications/Documents/determining-ideal-capital-structure.pdf
[3] http://www.fool.com/investing/general/2015/12/11/heres-your-guide-to-2016-interest-rates.aspx

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