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Since almost every aspect of a business is delicate, the owner(s) need to take care of all aspects to administer the business and develop it.
Capital structure is one of the aspects which plays a vital role in business development. In this, the equity and debt funds proportional arrangement are strategically made to raise capital for future operations. Proper adaption of capital structure is necessary for business. However, several factors should be considered and tracked before adapting a capital structure. These factors differ by the types of business forms. Let’s discuss this in detail.
Factors Affecting the Selection of Capital Structure: Overview
Before directly getting onto the topic, let’s glance at what capital structure is.
To begin with, capital structure is a combination of two words, capital and structure. All are familiar with the term ‘capital’, and it can be referred to as the funds invested by any owner into their business. There are two types of capital funds, namely equity and debt. The proper layout after sourcing and arranging these funds while keeping the future operations and development of the firm in mind can be said as the ‘capital structure’.
Capital structure is designed for the development of an organisation by raising funds strategically. However, every business has different factors affecting the capital structure; hence an appropriate capital structure of a firm is selected based on some factors. Some of them are discussed below.
Major Factors
Numerous factors affect the capital structure in different ways. However, all the affecting factors vary by the type of business. Although, some general characteristics, namely cost of capital, nature, and size of a company, capital markets, debt-to-equity ratio, and ownership, tend to land a high effect on the capital structure.
Cost of Capital
In a nutshell, the cost of capital can be defined by predicting the return that a firm needs to the cost spent on projects before considering it. This factor can save the firm from choosing such a capital structure which depicts the limit which shouldn’t be crossed while investing in the project, cutting the project costs. The cost of capital is the factor that determines the need of the type of capital structure, i.e., equity or capital. A firm needs to adapt.
Size and Nature of Business
The size and nature of the business are two crucial factors that shouldn’t be ignored while making capital structure. A small business faces difficulties in raising funds. This happens as they aren’t yet scaled enough and have less credibility for significant and long-term borrowings. Even if they remain successful in growing, they are bound to some disadvantages of poor debt-to-equity ratio higher interest rates, which harms the capital structure.
Similarly, the nature of business specifies the need for capital. Bottom-level businesses such as manufacturers, producers, and farmers demand high and more flexible capital structures.
Flexibility of Capital Structure
A structure should be flexible enough to cope with different market and business situations. The rigid structure can lead to a financial crisis or a shortage of funds in a business in emergencies.
Control on Business
Business ownership also affects the capital structure of a firm. Sole proprietorship or partnership firms have fewer owners, which advances to adjust the capital structure more easily as per the situations. On the other hand, public companies have the stakes of innumerable individuals, which can be the restriction point, making it inflexible.
Capital Market Conditions
Capital market conditions are also essential factors that should be taken into consideration. Capital market conditions can determine the cost of capital at the present time alongside risk issuing any new projects. On several conditions, people don’t want to invest in a firm owing to market volatility or the firm’s aspects. Similarly, in above normal market conditions, a firm shouldn’t raise funds at an increased cost of capital.
Debt to Equity Ratio of Firm
The debt to equity ratio is the financial tool that gives an accurate overview and need of the type of capital structure. Maintaining an optimal capital or equity structure is essential, and an increased inflow of debt capital can affect the capital structure. A poor debt-to-equity ratio also decreases stakeholder investments and credibility. Similarly, a good-performing debt-to-equity ratio increases the availability of a firm’s financial leverage, which in turn can be used on development or in an emergency.
Other factors
However, capital structure is a vast aspect of the business, and the development of almost all firms relies on it. Though, many other factors are also cross-checked before adaption. These factors can also be sudden in case of poor management of new government policies. However, coping with these factors is relatively easier than significant factors.
Earnings stability, state regulations, intensity of competition, growth period, credit history, cash flow, corporate tax rates, and other financial information are necessary factors. Moreover, equity trading, marketing potential, cash flow and availability of shares for dilution are some other factors that play a vital role in choosing the appropriate structure for the business.
Conclusion
From all of the above, we came through all the general and side factors necessary for adapting an appropriate capital structure in a business. Some main factors include the firm’s cost of capital, nature, size, capital markets condition, debt-to-equity ratio, and ownership. However, these factors might help to choose an appropriate capital structure for a business, but checking all the side factors can help adopt more appropriate and accurate adaption.
