optimal capital structure

What Is Capital Structure And Why Is It So Important To A Company?

What is capital structure and why is it so important to a company? Capital structure is defined as the meticulous balance between the equity of a business and debt that the business utilises to finance day to day operations, assets and future growth.

It comprises of the ease and expense of getting funding, expected return to lenders and investors, and how well-protected the business is from both business decisions and downturns in the economy. In other words, the risk profile of the business.

The capital structure of a company is an overview of lump sums owed to debtors – these claims are held in the form of access to a certain percentage of the future profit of the business. It is comprehensively analysed when determining how risky it would be for investment into the business, resulting in how expensive the financing structure would be.

Optimal capital structure

The key factors to bear in mind are that capital structure is how a company funds its operations and growth. The debt comprises of borrowed money that’s due back to the lender with interest, and the equity is the rights in the business without any need to pay back the investment. The risk of these borrowing practices can be determined by the Debt-to-Equity ratio.

Typically, a company that’s heavily in debt poses a greater risk to investors. However, companies do actually benefit from debt due to tax advantages with interest payments being tax-deductible. Debt also allows retained ownership, and in times of low-interest rates is easy to access. Using more debt than equity to finance assets has a higher leverage ratio and an aggressive capital structure.

Equity on the other hand, lets investors take partial ownership of the company. It’s more expensive than debt but doesn’t need to be paid back. This benefits companies with declining earnings. A company that pays for assets with more equity than debt has a lower leverage average and a conservative capital structure.

As a general rule there should be an appropriate mix of debt and equity capital in financing the assets of the business. Capital structure is designed to serve the best interests of the equity shareholders. A portion of long-term funding may be raised as a loan in the form of a bond by paying a fixed annual charge, which has proven to be a better way.

Advantages of a cash flow forecast

Cash flow management is extremely important to the survival of your business as it lets you see your current financial state. Managing resources properly means that you’ll never run out of cash and will be able to meet all business obligations.

Regularly performing a cash flow analysis will help make it easier to project future cash situations to ensure a consistently positive financial position. When you’re able to present an accurate cash flow forecast it shows how well your business is doing by providing a measured performance. This is essential in helping your business to function more effectively.

Making decisions regarding funding will also be indicated by analysing the cash flow forecast. Confirmation will be provided for buying new equipment, taking on more employees, or arranging alternative funding with lower repayment options that releases extra cash.

An effective cash flow management plan will serve to optimise the capital structure of your business.

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