Capital Structure

• Borrowing is desirable when profits are high. But it may be dangerous to depend on loans when profits decline. Then what should be the amount of borrowing for financing business activities? The general principle is to maintain borrowed capital and owners' capital in proper proportions. For a very successful business in favorable conditions, borrowed capital may be twice or even thrice as large as owners investment. But for a business which is suffering from declining profits, the proportion of borrowed capital should be as low as possible.
• Since borrowing of funds has distinct advantages, you may expect promoters to raise as large an amount as possible through loans. But beyond a certain limit borrowing may be risky. This is because fluctuation in earning and inadequacy of available cash could lead to a situation where it may not be possible for the business to pay interest and repay the amount of loan. In that case, the financial position of the business is sure to be looked upon by suppliers and creditors as unreliable. They may stop extending credit, and in an extreme situation, the business may go bankrupt or insolvent. This danger arises basically on account of the fixed payments to be made on borrowed, capital irrespective of the earnings and the shortage of available cash.
• The proportion of fixed interest bearing capital in the total capital is known as capital gearing. The capital is, thus, said to be highly geared if borrowed. capital is , proportionately very high in relation t.0 the ownership capital. Correspondingly, low gearing of capital signifies a smaller proportion of borrowed capital compared with the ownership capital. The composition of the total capital consisting partly of long-term funds with fixed charge and partly of ownership funds is known as the capital structure. Thus, capital structure refers to the relative proportion in which various sources of long-term finance are used to meet the total financial requirements, like debentures and long-term loans, preference share capital, and equity capital (including reserves and surplus).

Factors taken into account while deciding capital structure:

1. Nature of the business
2. Characteristics of the company
3. Management control
4. Cost of finance
5. Effect of debt financing on the earnings per equity share
6. Expected earning in relation to interest charges
7. Availability of cash (cash flow)
8. Flexibility of capital structure