In our daily lives, even the simplest choices can have a big impact. Making the best decision on how we manage our financial capital structure lives us with that subsequent good feeling in our businesses. For instance, decisions on capital structure changes have an effect on several stakeholder sectors globally. In effect, they may create conflicts of interest, such as a debt-equity conflict, in an effort to increase investors’ wealth or their personal wealth. In this article, we define the optimal financial capital structure management types and the factors influencing their change.
To fully understand this specific issue, let’s now define financial management.
Financial Management—What Is It?
Financial management, to define it simply, is the planning, organizing, and controlling of all business transactions. It also includes investing in the available financial resources, whether through a public offering, debt financing, private equity, or any other method, including initial personal investments. Greater economic success and a return on investment (ROI) later drive the growth of the firm.
Capital Structure in Financial Management
We can define the capital structure in financial management as the blend of equity and debt that a business uses to finance both its growth and its general operations. In addition, capital is the most important factor in starting a company. It serves as the business’s pillar.
In this article, the two main sources of capital for a firm are debt and equity. Also, we define the financial capital structure in management as the ratio of short-term to long-term debt that must be taken into account.
In addition, managing a company’s financial capital structure uses a debt-to-equity (D/E) ratio, which focuses on how risky its borrowing practices are. A business with a high debt load often has a high level of risk and is therefore unsafe for investors. However, it’s likely that these risk decisions define the capital structure of any type of financial management growth.
What Is Debt-to-Equity Ratio
Calculating the debt-to-equity ratio shows how much any company is using to finance its liabilities and equity. Also, you can determine the company’s equity by deducting its entire liabilities from its total assets. Moreover, stating it as a percentage or decimal is great.
The debt-to-equity ratio is key since it gives insight into the financial power of a firm.
Types of Capital Structure in Financial Management
Using various long-term funding sources in a financial management capital structure includes sharing capital. Moreover, it includes two major types: equity and debt. A company may raise money via a variety of methods, such as equity shares, retained earnings, and long-term loans.
Getting money from owners or partners of a company means “equity capital.” It has two different types.
#1. Retained profits
Equity capital deals with holding gains that are part of the organization’s profit, which is set aside for the firm’s growth.
#2. Contributed Capital
Owners donate some amount of capital when starting a business in exchange for a part of the company.
The term “debt capital” refers to borrowed funds used by businesses. Different types of debt capital exist.
#1. Long-Term Bonds
These bonds are the safest loans since they have a long payback time and only require interest payments; the principle is due when the bond reaches maturity.
#2. Short-term Commercial Paper
This is a particular kind of short-term financial tool that businesses use to raise money quickly.
Optimal Capital Structure in Financial Management
The optimal capital structure in financial management is the best mix of debt and equity financing. Also, it helps a company increase market value while lowering its cost of capital. In addition, different industries have different capital structures for financial management. A high debt ratio is not good for a business engaged in mining or oil and gas production. However, several sectors, such as banking or insurance, have high debt levels as part of their capital structures.
For instance, a business that is growing quickly can have a larger debt-to-equity ratio than one that is older as well as stable. Also, if the business has a very high debt load, issuing extra debt may not be an option since bondholders are unwilling to extend further credit. The company could have to issue more equity in this situation.
Furthermore, a variety of factors, such as a firm’s tax rate, the changes in its profits, the cost of issuing new shares, and a company’s capacity to service its debt, determine the optimal capital structure. The optimal capital structure in financial management will likely change as a company’s needs change over time.
The Importance of the Optimal Capital Structure for Financial Management
Financial capital structure management is important in every business because of its unique needs. For instance, a global firm’s cash flow and financial support needs are likely to be more complex and challenging than those that are just starting.
Furthermore, it is important to note that corporate entities act differently from sole owners when it comes to risk analysis and debt management.
In general, it is important to consider how risk assessment and debt management will differ for corporate organizations versus business owners when developing and managing capital structures. Businesses can create an optimal financing structure that supports their efforts and uplifts others over time, beginning with a strong foundation that limits liabilities, maximizes cash flow, and pays attention to the ratio of debt to retained earnings.
Factors Influencing Capital Structure in Financial Management
A company’s capital structure has a big influence on factors like the return to partners, the cost of capital, and firm value. As a result, it is crucial to consider the factors influencing firms while designing their capital structure. These are referred to as the capital structure influencing factors.
Generally, the country’s economic and industrial state, major factors unique to a particular concern, and specific elements are taken into account while designing the capital structure.
The following factors influencing the capital structure in financial management can be divided into internal and external factors:
The following are some internal factors influencing the types of capital structure in financial management.
#1.The Type of Business
The types of capital structures in financial management affect the way any type of business activity is viewed by investors. In addition, compared to companies that exist in markets of perfect competition, those that operate in monopoly or oligopoly markets often have a stable income and low business risk.
#2. The company’s size
Small businesses usually have low capital needs and rely mostly on their own resources. Moreover, these businesses frequently face strict lending from financial institutions, which forces them to steer clear of debt capital.
On the other hand, large businesses can rely on debt capital since they have easy access to finance. Also, they have higher financing needs that are seldom met by new issuance.
#3. Income Stability
One of the factors influencing the management of the financial capital structure in most businesses is income stability. For instance, firms with uneven income struggle to keep up with the cost of fixed-charge capital and should thus aim to stay away from it.
#4. Cost of Capital
Similarly, equity and debt capital often have lower costs. So, a rise in debt capital can lower the total or average cost of capital a little. Therefore, a company that wants to reduce its cost of capital must raise the share of debt capital in total assets.
The types of any company’s financial management capital structure should be flexible. Additionally, due to fixed exchange rates, a company may prefer complex borrowed funds or preference shares to normal equity shares.
#6. Goal of Financing
Because fixed costs are easily covered by regular income, a company may rely on debt capital or preference share capital to support its regular operating activities.
#7. Project Duration
The capital structure types in any company’s financial management should perfectly align the maturity profile of the instruments with the time of the projects. As a result, it can finance projects with set completion dates using sources like debt capital.
#8. Control Over the Company
Since debt holders and preference shareholders do not have voting rights, getting more funding from them does not affect the current shareholders’ ability to exercise control over the company.
A company’s capital structure should be flexible. Additionally, due to fixed exchange rates, a company may prefer complex borrowed funds or preference shares to normal equity shares.
#10. Transfer of Assets
A company should refrain from using long-term capital sources to pay for current assets. Additionally, some of the fixed assets may be paid for with long-term debt capital that has a similar maturity.
#11. Investing with Equity Capital
The ability to enter into trading on equity and the desire to do so influence a firm’s organizational structure. A firm can increase the return to partners when its rate of return exceeds the cost of fixed charge capital.
#12. Management’s Mentality
One of the factors influencing the capital structure in financial management is the mindset and view of management toward financial risk. As opposed to those with conservative management, fiercely run companies are shown to rely more on debt.
#13. Age of the Company
Institutional financing is often difficult to get for young enterprises with unknown futures. They thus rely more on unusual funds, such as private equity.
The following are some external factors influencing the types of capital structure in financial management.
#1. Financial Market Situation
The state of the capital markets changes throughout the year. As a result, whereas new issues are often overrun in a growing capital market, they are difficult to sell during a crisis.
#2. Interest Rate Level
In times of high-interest rates, a company with a relatively poor rate of return may choose not to borrow money because it cannot pay the high interest.
#3. Investors Mentality
Companies will find it difficult to sell securities in the market and rely on institutional loans to cover their funding needs in an economy where investors are largely risk averse.
#4. Regulatory Conditions
Different rules are issued by market officials in each nation for securities issuers to follow. For instance, banking firms are only allowed to issue equity shares as securities.
#5. Tax Policy
For instance, in India, local firms that pay rewards are subject to a share distribution tax, which increases the cash outflow required for equity share financing.
#6. Government Regulations
Companies find it simple to raise funds needed by giving fresh shares when the government uses a liberal policy and allows foreign institutional partners to join in the capital market.
The ratio of short-term to long-term debt is considered while managing the financial capital structure of any sort of firm since it focuses on how risky its borrowing practices are. Moreover, a company with a high debt load sometimes has a large amount of risk, which influences investors’ interest in the company. But it’s possible that this risk is what powers the business’s optimal growth.
- PRODUCT LINE MANAGEMENT: Definition, Examples & How It Works
- ORGANIZATIONAL DESIGN STRUCTURES: Organizational Design Principles & Examples
- Capital Market Analyst: Job Description, Responsibilities, Salary & More
FAQs: Capital Structure in Financial Management
What Is the Basic Goal of Financial Management With Regard to Capital Structure?
The aim of any management action is to maximize total assets.
What Are the 5 A’s of Financial Management?
Anticipation, Acquisition, Allocation, Appropriation, and Assessment of Funds are all included in the scope of financial management.
What Is the Difference Between Capital Structure and Financial Structure?
A capital structure is a mix of many long-term funding sources. A financial structure is a mix of many long- and short-term sources of funding. The balance sheet’s liabilities column includes information on the capital structure.