What is Capital Structure?
Capital structure refers to the proportion of debt and equity used for financing operations of the business. Let’s discuss more about it.
Concept of Capital Structure
After determining the financial requirement, the next step under financial decision is to decide the composition of capital structure. This involves deciding how much funds to be raised from each source of finance. Hence, capital structure decision involves deciding on the kinds of securities to be issued and their relative proportion in the capital.
What are the sources of business finance?
The sources of business finance are classified into two categories:
1. Owner’s fund (Equity)
It includes equity share capital, preference share capital, and retained earnings. Retained earnings include reserves and surplus.
2. Borrowed funds (Debt)
They are in the form of loans, debentures, public deposits, etc. It could be borrowed from banks, other financial institutions, debenture holders, and the public.
Capital structure is the mix between borrowed funds (debt) and owner’s funds (equity).
Important points about debt
- Debt is a borrowed fund, whereas, equity represents owner’s fund.
- Debt is cheaper as compared to equity, because interest paid on debt is a deductible expense for computation of tax liability. Dividends on equity are paid out of after tax profits.
- Debt is more risky as compared to equity, because interest payment and return of principal in case of debt is obligatory for the business.
Any default n meeting these commitments may force the business to go into liquidation. On the other hand, equity is considered riskless as there is no such compulsion. So, increased use of debt increases the financial risk of a business.
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