Capital Structure

Key Highlights

• Capital Structure is the combination of debt and equity a company employs to finance its growth and operations.

• Components of capital structure includes equity and debt capital.

What is Capital Structure?

Capital Structure is the combination of debt and equity a company employs to finance its growth and operations. Simply put, it indicates how a company raises funds—borrowing (debt), issuing shares (equity), or a combination of both.

Components of Capital Structure

1. Equity Capital

• Common Shares: Held by ordinary shareholders with voting rights.

• Preferred Shares: Shareholders receive fixed dividends but generally don't have voting rights.

• Retained Earnings: Profits re-invested in the company rather than paid out as dividends.

2. Debt Capital

• Short-Term Debt: Loans, overdrafts, or commercial paper due within one year.

• Long-Term Debt: Bonds, debentures, or term loans due over a few years.

• Convertible Debt: Debt that can be converted into shares at a later date.

Capital Structure Formula

There is no one fixed formula, but one of the ratios most often used to comprehend capital structure is the Debt-to-Equity Ratio:

Debt-to-Equity Ratio = Total Debt/Total Equity

This indicates how much debt a firm employs in comparison to equity. A ratio of 1 signifies that the firm employs equal proportions of debt and equity.

Capital Structure Example

Assume a firm has:

• ₹30 crore as equity
• ₹20 crore as debt

Its capital structure is:

• Equity = 60%
• Debt = 40%

Why Capital Structure Matters?

1. Risk Management

• Increased debt translates into increased repayment obligations and increased risk.

• Increased equity minimizes risk but can dilute ownership.

2. Cost of Capital

• Debt is less costly (interest is tax-deductible), but excessive increases risk.

• Equity is costly (dividends are not tax-deductible), but safer.

3. Investor Confidence

• An optimal capital structure demonstrates financial health and sound governance.

4. Business Flexibility

• Firms can finance in a manner best suited to their market environment and objectives.

Optimal Capital Structure

There is no single "one-size-fits-all" optimal structure. The optimal capital structure is the combination of debt and equity that:

• Reduces the cost of capital overall

• Maximizes the company’s value

• Maintains financial stability

Capital Structure vs Financial Structure

Capital Structure	Financial Structure
Includes only long-term debt and equity	Includes all liabilities, short-term and long-term
Focused on strategic financing	Broader view of company’s liabilities