Big stories start with humble beginnings. Big businesses always start with a small but brilliant idea. Apart from an idea, cash for people, place and equipment and documentation is also required. So, if the basic capital structure of small business is decomposed into elements, one can find:
a. Cash flow
b. Infrastructure – may be just a room or desk or a garage
c. Equipment – A computer, a software or manufacturing kit
These are the three main elements that form the pillar of support for a small business to start, sustain and grow. Apart from these, people are also an important asset without which these elements will mean nothing.
A business whether small or big has an identity. This identity is defined by its capital structure. The capital structure comprises of important features, such as:
a. Capacity: Equipment, people, manufacturing space, materials and finished goods storage space determine the overall capacity of a business. By capacity, economists mean the order size that is possible for a business to process, first of all. It also implies how long this business will be around, which, in turn, is determined by its growth rate. Another feature of capacity is its ability to combat unfavorable conditions.
b. Flexibility: Capital structure should be having a feature of flexibility. A business tends to go upwards as well as downwards according to the phase it is in. The capital ecosystem should be supportive of cases of both the growth and the recession.
c. Liquidity: The structure of capital should have element of liquidity. There has to be no dearth of usable cash called liquid equity. Liquid cash is essential for meeting daily expenses, materials procurement, vendor payments and also repayment of loan.
d. Debt repayment ability: Ability to repay debt determines the solvency of the business. By the virtue of debt repayment capacity, the business earns the confidence of investors. It earns credit-worthiness that is required to sustain the business for times to follow.
e. Control: The capital structure should be supportive of control by the business owners. If there is too much of debt component, the likelihood of takeover of business by investors increases. Thus, one has to monitor the debt-equity ratio closely and regularly.
f. Profitability: It is the crux of any business model. A business becomes viable only when it generates profits for the owner as well as the stakeholders. Thus, designing the capital structure for conservative perspective is advisable so that the profit surpasses the debt. It helps in retaining the interest of investors and stakeholders in the company.
Bringing vision into reality requires research, evaluation of alternatives and possibilities, attainment of required resources and critical assessment of the placement of business amidst the favorable as well as unfavorable scenarios. All this is possible when the capital structure supports these activities.
Therefore, the first objective is to allow the business to happen. To achieve the very existence of the business, is the reason why one needs capital structure.
Second objective is to maximize the profits. Earnings are the reason why any person starts business. A business is able to deliver the promises it makes to consumers only if it has ample capital to support the expenses as well as expansion or growth, and in some cases, diversification plans.
Third objective is to have better control by reducing the cost of capital. Raising capital does involve cost. The company requires issuing securities, bonds, etc. to the investors to raise capital. Debt financing also attracts cost in the form of interest payable on the loan availed. Control is easy to perform when the debt-equity ratio is low. This ratio when low shows that the actual value of the business is able to cover the debts and that at the time of crisis, no stakeholder will face any kind of crisis.
Arising from third objective is the fourth objective which is crisis management. A crisis can be reduction in demand, a complete sweep of the market by competitor, some regulatory issue, or even something falling under force majeure. In any of these situations, the business continues to have its identity and does not crumble down owing to the presence of
Debt, preferential shares, equity shares, debentures, etc. are some of the components of a typical capital structure of the business. A company depending upon its confidence, proposed term of operation and effect of the external conditions chooses a capital structure. Creating this structure of capital depend upon following factors:
Decisions regarding borrowing funds depends upon this ratio. It is determined by
ICR = EBIT/Interest
EBIT means Earnings before Interest and Tax. If this figure is way higher than interest amount to be paid, then it is viable for the business owner to raise funds through borrowings.
Suitability to have more debt in capital structure is determined by debt service coverage ratio. When the sum of profit after tax, depreciation, interest and written off expense of non-cash nature exceeds the sum of Preference dividend, repayment obligation and interest, it shows that the company is in good health. It will be able to cover the debt repayment obligation comfortable by profits made despite the depreciation and other writing offs factored in.
Earnings made per unit of investment amount is an important factor in determining the capital structure. If ROI exceeds the interest payable, the company can continue to work and stay strong with debts. Thus, borrowing does not pose risk to the entity if it is making enough earnings to cover the interest. In case of reverse, the business needs relying on the equity part more and should avoid borrowing.
Thus, capital structure is indicative of several things about the business. It is quite easy to determine the overall health of the company by taking a look at the structure. People engaged in investing in company through shares and debentures take investment decisions depending upon the capital structure and its existing components.
Jul 29, 2020