While starting a business, capital is one of the most important funding sources. However, to gain it, money is borrowed, or equity is shared. This can be problematic as one cannot take on a lot of debt or dilute all equity. Thus, organisations create capital structure design, which provides them with clear ideas about how capital should be funded as debt or equity.
The designing of a capital structure meets all of the financial obligations of an enterprise. Hence, in this article, we will understand the steps and factors that need to be followed before designing the firm’s capital structure.
What is Capital Structure?
The capital structure is a mix of equity and debt used to manage the business and run the operational processes while fostering the organisation’s growth. The total capital of a company is made up of two types: equity and debt capital. Equity capital comes from an organisation’s shares and asserts its cash flows and earnings. Debt is represented by bond issues or loans, whereas equity is represented by common stock, preferred shares, or net cash.
A company’s capital structure must be designed to effectively manage the capital base to exploit possibilities, risk management, and meet the demands of the business. Some practices in capital structure design as used by businesses are discussed below.
Importance of Designing Capital Structure
Finance is one of the most critical materials for any business, and capital structure is expected to control it properly. Capital structure is important in any business because it maximises the firm’s market value and raises the interest of the investors in a company. It can also increase a company’s capital structure by increasing its opportunity to participate in future wealth-creating investments. In addition, financial leverage reduces the firm’s cost of capital or cost of funds by determining an appropriate mix of funding sources. Not only this, but the capital structure has many more important things, including the investment opportunity increases, etc.
Steps followed while Designing a Capital Structure
Designing a capital structure is important for a firm. Hence, we share some of the steps followed while designing the capital structure.
- Select the sources to meet the company’s capital requirements
A company requires capital to meet performance demand, which necessitates funding. However, there is no single source available to get the funding. So, while designing a Capital structure, Top companies scan their available funding sources, the benefits and drawbacks of equity and debt, and the capital cost to comprehend the financial, regulatory, and operational risks they will most likely face.
- Another best practice in capital structure design is the ongoing effort to reduce capital costs
Top-level management struggles to reduce their capital cost. Financial transparency is a best practice that companies use to find investors who give their capital at a lower cost than competing companies. They maintain positive relationships with banks to obtain favourable lending rates, positively affecting lucrativeness.
- It is critical to constantly explore alternative finance sources when designing a capital structure
Best practice companies are constantly looking for alternative non-traditional types of financing and trying to shift away from dependency on conventional capital sources such as financial institutions, stock markets, or institutional investors to avoid being victims of market changes. They form alliances with other businesses, use assets as collateral, and build corporate structures to safeguard the holding company from overburdening risk.
- Actively managing flexible capital effectively is also a sound capital structure design practice
Companies that follow best practices are assertive in balancing debt to equity ratios to answer various factors impacting capital costs. Many businesses benefit from flexible financial policies regarding dividends, in which the need can be paid as dividends, and the remainder is maintained to grow the business.
- Align your capital structure according to your company’s strategy
Companies must evolve a capital mix that endorses the company’s strategy while leaving plenty of flexibility to adjust to changing business environments when designing the capital structure. While designing a capital structure, top-tier companies focus on the organisational goals and operational superiority by determining the proper threshold credit risk and implementing disciplined capital management tactics for a business.
- The most effective way to design capital structure is first to determine the company’s financial statement
To precisely determine the capital investment threshold, notable companies need to be aware of one’s capital costs. Obtaining a company’s overall capital cost is a common method for calculating capital cost (WACC).
The WACC blueprint is simple, but it can be complex by the varying input that defines its result. Successful businesses measure their capital cost regularly to keep track of how much money they make or lose. Companies that use various methods of calculating WACC gain a broad understanding of their role and can make better strategic choices in dealing with the sector and its competitors.
Conclusion
Capital is the most important resource required to run an industry, so it requires a defined structure to keep the company running. A company can obtain funding from various sources, including debt which needs to be paid, and equity, which needs to be shared, for which a suitable structure should be discussed. Designing capital structure entails several methods such as selecting sources to meet the company’s capital requirements, reducing capital costs, effectively designing the capital base, and much more. That is why you need to understand what capital structure is, how to design it, and the factors that influence it.
