Capital structure or financial structure or capital plan of a company is the make-up or composition of capitalisation, i.e., the types of securities to be issued, as also the relative proportion of each type of securities in the total capitalisation.
The ratio between the various types of securities to total capitalisation goes by the name capital gearing. In other words, it is the ratio of fixed interest securities (debenture loans and preference shares) to the total capital.
High capital gearing means that the proportion of non-equity capital is relatively high. Low capital-gearing implies that the ratio of non-equity capital to equity is relatively low.
There is a relatively larger proportion of equity capital in total capital under low gearing (or financial leverage). By contrast, a relatively high proportion of fixed-interest securities in total capital implies high gearing. The following example will make the distinction clear. The figures (in Rs. ‘000) are all hypothetical.
The ratio of loan debt capital to risk equity capital is of some significance because it has considerable influence on the variability of the returns from investment. The ratio of a company’s ordinary share capital to that part of the capital which carries a fixed rate of interest (preference shares and debentures) is known as the gearing of the capital structure.
The larger the proportion of ordinary to other capital the lower the structure. In fact, the relationship between equity funds (net worth) and fixed-income bearing funds (debentures, preference shares and other borrowed funds) is called the capital gearing ratio. It is a useful ratio because it shows the effect of the use of fixed-interest/dividend source of funds on the earnings available to the equity shareholders.
Thus, if profits are rising, the dividends on ordinary shares will rise very much faster in those companies with high gearing than falling. If the profits are unchanged, but proportions between the ordinary shares and the fixed interest securities are varied it will be found that dividends on ordinary shares are much more variable when the gearing is greater.
In case of capital gearing, three factors are to be taken into consideration in evolving a sound capital structure, i.e., in assigning the relative importance to owners’ capital and debt capital.
The three factors are the following:
1. The volume of expected earnings
2. The stability of earnings
3. The predictability of earnings.
Those companies whose anticipated earnings are well above interest and sinking fund needs, the earnings are not volatile (or are fairly stable), certain and regular and whose success is more or less assured can rely more on loan capital or on bond finance. For a well-established company these conditions are normally specified in advance.
Hence in case of such a company there may be quite a high proportion of borrowed capital to owners’ (equity share) capital. By contrast, a new enterprise should not rely much on loan capital not only due to irregularity or uncertainty of earnings, but also due to lack of goodwill. Too much reliance on borrowing (i.e., on bond or debenture capital) may impose considerable financial burden on such companies.
If the success of a company is quite assured but the company is not quite certain about its earnings, it can rely on preference share capital. Preference shares are suitable when the earnings are irregular but on an average there is a fair margin over the preference dividends.
Equity share capital is always desirable under adverse conditions, i.e., when earnings of a corporation are not only unpredictable and irregular, but uncertain and fluctuating as well. A speculative business, for example, not only runs the risk of considerable profit fluctuation, its immediate prospect of profitability is also bleak. So such a company can only raise equity share capital.
In the ultimate analysis, it appears that the determinants of a sound capital structure of a company in case of gearing depends largely, if not entirely, upon its financial position and earning power. Conservative investors have usually a special liking for bonds and preference shares. Institutional investors also show a similar preference due to legal restrictions on their approaching the capital market for equity shares.
Bonds and preference shares also have a special appeal during recession and depression. The proportion of these two types of capital in the total capital of a company depends upon three factors: the company’s financial position, its earning power and the security that can be offered by the company.
The proportion of preference shares depends on the first two factors. If investors are guided by safety, regularity and security of income and capital, bonds and preference shares seem to be most suitable in a company’s capital structure.
There is demand for equity capital in periods of business prosperity which are also characterised by inflation. In such periods both dividends and market value of shares rise. It is the task of management to evolve a proper mix of variable income securities (equity shares) and fixed income securities (debentures and preference shares) on the basis of these criteria.
Usually, for a new company, at least 70% of total capital should consist of equity capital and the balance (30%) preference share capital and loan capital. In case of an established and at the same time a growing company (requiring more and more capital for expansion and diversification) there should be an equal proportion of both. An optimal capital structure refers to an optimum combination of share capital and loan capital.